The BizQuest Team Published July 12, 2023
What Is EBITDA? A Guide to This Essential Business Valuation Metric
The BizQuest Team
In the ever-complex world of business transactions, one metric often stands out for its applicability and insightfulness: EBITDA. An acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization, EBITDA provides a comprehensive view of a company's profitability. By stripping away financial, accounting, and tax complexities, EBITDA can serve as common ground for understanding and comparing businesses across diverse industries and sizes.
But what is EBITDA? Why is it a crucial tool for business leaders, buyers, and sellers? How is it calculated, and what differentiates it from other financial metrics? This guide delves into EBITDA, its definition, calculation, and significance in business valuations, with an emphasis on its role in lower mid-market business transactions.
Defining EBITDA
EBITDA provides a more focused view of the company's ability to generate profit from its fundamental operations by excluding financial considerations, such as interest payments, as well as non-cash expenses, like depreciation and amortization. One important factor of note is that EBITDA is not considered a financial metric under GAAP (Generally Accepted Accounting Principles) to be listed in financial statements.
Additionally, any downstream metrics (e.g., Adjusted EBITDA, EBITDA Margin, etc.) would not be considered GAAP approved. Because EBITDA is not a GAAP financial metric, different firms may calculate it differently. There can be ways of adjusting EBITDA that are inconsistent from company to company. For buyers and sellers, this can have a meaningful impact on valuation.
If you’re valuing the business on a multiple of EBITDA or trying to compare multiple businesses, it can be difficult if there are underlying differences in how it’s calculated. As a buyer, it’s imperative that you understand how a seller or broker is calculating EBITDA and that you’re doing your own analysis based on their income statement.
The Importance of EBITDA
Understanding EBITDA is fundamental for all stakeholders as it provides an uncluttered view of a company's core operating performance by excluding elements like interest, taxes, depreciation, and amortization, which can differ greatly among businesses.
For business owners, EBITDA can mirror the effectiveness of core business strategies, helping them fine-tune operational adjustments. Sellers might leverage EBITDA to illustrate the firm's profitability in the best light, boosting its market value. Buyers often use EBITDA to assess the real operating profitability, cutting through the financial and tax strategies that might distort bottom-line earnings. Even lenders and investors analyze EBITDA to evaluate a company’s ability to service debt and compare financial performance without the interference of diverse accounting practices.
However, the strength of EBITDA also lies in its complexity. Its wide-reaching applicability requires a nuanced understanding of what has been excluded from the calculation. Factors such as capital expenditures needed to maintain assets, variations in working capital, tax rates, or specific one-time adjustments can all influence EBITDA. All these metrics would typically impact net income but are excluded in an EBITDA calculation.
One way to illustrate the impact of these factors is through the example of a relatively straightforward business. Say, for example, you’re the owner of a fitness business. Your basic earnings would be generated through the collection of monthly membership fees, any personal training sessions, and the sale of any additional merchandise. On the other hand, your operating expenses would be all of the equipment maintenance, salaries for your employees, and any recurring costs. The difference between these two numbers is your EBITDA. It’s an indicator of the overall health of the business and a directionally helpful metric in understanding the value of the business.
In any given month, certain events may materially impact the business. For instance, you may be investing in new equipment, which would impact the business’s balance sheet and income statement, but be excluded from EBITDA. This gives EBITDA the value of helping an outside party evaluate a business over the long term and against other businesses. But, of course, it is an incomplete picture of the business.
A company’s EBITDA is a vital, yet multifaceted tool that offers insights into a company's financial health and intrinsic value. It serves as both a gauge and a guidepost, assisting various stakeholders in making strategic decisions in buying, selling, and managing businesses. Its usage within the business community underscores its importance in fostering more transparent and equitable transactions.
How EBITDA Impacts Valuation
While EBITDA is a powerful tool, it's essential to recognize its place within a broader valuation context. It should be used with other metrics, as relying solely on EBITDA could overlook significant factors, such as growth potential or market positioning. It's not a standalone measure, but a vital part of a comprehensive toolkit.
When thoughtfully integrated into business valuation, EBITDA can be a nuanced and indispensable metric. It aligns different businesses on a common ground, allowing buyers, sellers, and investors to peer through the financial fog and discern the company’s intrinsic, operational value. This ability to cut through complexity while retaining analytical depth underscores the significance of EBITDA in modern business transactions and valuations. One manner by which EBITDA can be leveraged is in valuation ratios. For example, comparing EBITDA across businesses in a similar industry can help inform how the business you’re either buying or selling should be valued.
When is SDE Used vs. EBITDA?
The main difference between EBITDA and SDE lies in their application and focus. EBITDA seeks a broader and more standardized perspective, catering to the needs of larger businesses and more formalized transactions. SDE, conversely, recognizes the unique nature of small business operations, where personal and business finances may be closely interwoven and where the cash flows might be a more critical measure of value to owners.
Choosing between EBITDA and SDE is not merely a matter of size, but also of the business's structure, industry, and the specific requirements of buyers or sellers. The nuances between these two metrics reflect different valuation philosophies and require thoughtful consideration based on the business's unique context.
Understanding the precise role and relevance of each in your specific situation can greatly enhance the accuracy and fairness of your business valuation. For small businesses, often below $1M in value, SDE is a more appropriate metric to use. In many of these cases, the business is likely run by a sole proprietor that may have passed some personal expenses through the business, impacting net income and EBITDA. By adding back in some of those personal expenses, you can get a better view of the potential earnings of a business. Inversely, larger businesses are less likely to have the same dynamics, thereby making EBITDA a more appropriate metric.
Calculating EBITDA
Calculating EBITDA isn’t always straightforward, and variations in the formula may be required based on the company's unique financial structure and the specific purposes for which EBITDA is being used.
Here's one way to perform an EBITDA calculation:
Start with Operating Income (EBIT or Earnings Before Interest and Taxes): This figure represents the company's earnings from its core business operations, disregarding interest and taxes. It's a more focused representation of operational profitability and can be found on the income statement. To arrive at this figure, you'll need to have insights into other key financial elements, such as total revenue and the cost of goods sold (COGS). Subtracting COGS and operating expenses from total revenue gives you the operating income, offering a more nuanced look at the business's health.
Add Back Depreciation and Amortization: These represent non-cash expenses related to the wear and tear of tangible assets (depreciation) and the gradual reduction in the value of intangible assets (amortization). Adding these back gives a clearer picture of cash generated from operations.
Consider Adjustments for Non-Operating Income or Expenses: Some companies may include or exclude certain one-time or non-operating items. Examples are gains or losses from the sale of assets, legal settlements, or restructuring costs.
Include or Exclude Specific Interest Expenses: Depending on the specific needs of the analysis, some interest expenses might be added back, especially if they are considered non-operating.
EBITDA Formula
The formula may be expressed as:
Imagine a company with the following financial information:
EBIT (Operating Income): $550,000
Depreciation: $30,000
Amortization: $40,000
Using the above formula, we calculate:
EBITDA = $550,000 + $30,000 + $40,000 = $620,000
This example illustrates one very simple approach to calculating EBITDA. It is worth noting that the exact calculation method can vary depending on industry practices, specific business circumstances, and the intended use of EBITDA. In some contexts, there may be other adjustments that are expected to be added. Additionally, professional advice may be sought to ensure the most accurate representation.
Using EBITDA
By accurately calculating and understanding EBITDA, stakeholders can better understand how well a business is operating and, ultimately, how it should be valued. For anyone involved in buying or selling small to mid-market businesses, EBITDA provides valuable insight into the intrinsic value and the market value of a business, contributing to fairer and more transparent transactions.
BizQuest has many tools and resources to help you get started on valuing a business, whether you’re buying, selling, or just looking for a valuation benchmark:
