Have you chosen to sell your business to a buyer or investor? If so, it's vital that you determine the value of your business and plan accordingly. The decision to sell a business takes a lot of thought, and many factors need to be considered to make sure you're asking for the right price. While there are a variety of valuation methods used by business owners today, EBITDA is effective for measuring your company's potential value in a sale.
What Is EBITDA?
EBITDA is a calculation used by business owners to measure a company's financial performance rather than focusing solely on other metrics like revenue, earnings, or net income. Many business owners choose to use EBITDA because it focuses on the financial outcome of a company's operating decisions by removing the impacts of non-operating decisions like interest expenses, tax rates, and intangible assets. By eliminating these impacts, a business's operating profitability is better reflected, which makes a comparison between companies more straightforward and realistic.
The acronym EBITDA is expanded below:
- Earnings: A company's net profit or net income.
- Before: Certain factors are excluded from the equation as they are already subtracted from net profits. The EBITDA calculation will add them back in, making the EBITDA total higher than the net profit.
- Interest: Expenses to a company caused by interest rates, like short-term business loans provided by a third-party provider or bank.
- Tax: Federal, state, and local taxes are determined by the company's location and aren't an indication of its profitability or viability.
- Depreciation: A non-cash expense that resembles the gradual reduction in the value of a company's assets. Depreciation matters for some companies more than others and is not an indicator of a company's overall performance.
- Amortization: A non-cash expense that resembles the cost of intangible assets over time. Company debt or amortization is also not an indicator of a company's overall performance.
Calculating and applying EBITDA is essential for business owners because it allows you to get a clear idea of your company's value and demonstrates your company's worth to buyers and investors. EBITDA will help you analyze and compare profitability between competitors, so you can see where your company stands in your given industry.
EBITDA vs. EBIT
The main difference between EBITDA and EBIT is solely the number of steps taken in the calculation process. While EBIT allows the discernment of earning value without the impact of interest and tax rates, EBITDA's unique capability to identify and remove expenses related to depreciation and amortization makes it a valuable tool. There is another measure known as EBITDAR - earnings before interest, taxes, depreciation, amortization and restructuring or rent costs - which is useful in industries with high rental costs. Many business owners find using all these calculations—EBIT, EBITDA and EBITDAR—beneficial as each offers a clear understanding of the company's different financial aspects. If you're curious about how to calculate EBIT, the equation below can be used.
EBIT = Net Income + Interest + Taxes
EBITDA vs. Net Income
As a business owner, you're aware that EBITDA is an indication of your company's ability to make a consistent profit. This concept is vital in determining your financing structure. Additionally, it's crucial to realize that EBITDA is also a standard profitability measure that allows for comparability. This comparability not only facilitates the evaluation of operational efficiency but also empowers stakeholders to align the financing structure accurately while gauging the profitability of different companies across industries and regions.
On the other flank, net income outlines a company's total earnings, providing a key snapshot of financial well-being and helping to shape its financing strategy. The vital divergence lies in the fact that while net income is utilized to figure out the value of your business's earnings per share, EBITDA measures the business's overall earning potential, therefore influencing the strategic planning of the financing structure.
Formula: Net Income = Revenue - Business Expenses.
EBITDA vs. Operating Income
After subtracting your company's operating expenses like depreciation or amortization from the overall profit, you get your operating income calculation. EBITDA, when used in conjunction with an exit strategy, helps provide a clear snapshot of a company's profitability by isolating these operating expenses. As well as this, the Last Twelve Months (LTM) EBITDA can be combined with the preceding 12 months' performance. Both EBITDA and operating income calculations prove instrumental in valuing your business, as they allow for a comprehensive assessment of your company's core operational productivity and overall expense management.
Furthermore, by calculating the EBITDA coverage ratio (sum of lease payments and EBITDA divided by the sum of principal, interest payments and lease payments), you can gain insight into the company's ability to cover its financial obligations. This is particularly important when formulating an exit strategy as it not only can be used to present desirable financials to potential buyers but also helps in taking numerous business decisions.
Formula: Operating Income = Gross Profit - Operating Expenses - Depreciation - Amortization.
How to Calculate EBITDA?
To develop an accurate EBITDA calculation, you add the non-cash expenses of depreciation and amortization back into your company's operating income. To kickstart the process, you need to dig out your company's net income (total earnings or losses) as the first step of calculating EBITDA. Using an online EBITDA calculator can help. But if you're not sure how to do this, the foundational EBITDA formula enlisted in this table of contents is straightforward:
Formula: EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
The importance of accurate EBITDA calculations and maintaining proper data stretches far beyond mere accounting practices. If you plan on exiting the business, it enables you to present financials, including EBITDA, stretching back 3-5 years. By showcasing such data, you can illustrate the company's growth over time to potential purchasers, indicating a promising future.
Understanding the EBITDA formula
EBITDA is an acronym representing Earnings Before Interest, Taxes, Depreciation, and Amortization. It's an essential calculation used for formulating profit projections, and it is calculated in two main ways: either moving forwards starting with gross income or backwards, starting with net income.
When calculated backwards, it's expressed as:
EBITDA = Net Income + Interest Expense + Tax Expense + Amortization Expense + Depreciation Expense
When calculated forwards, it's expressed as:
EBITDA = Revenue – Operating Expenses (not including interest, tax, depreciation and amortization) – SG&A expense (Sales, General & Administrative)
By estimating EBITDA, you can gauge a company's operating profitability before non-operating expenses (such as interest and "other" non-core expenses) and non-cash charges (depreciation and amortization). Since EBITDA can be manipulated by changing depreciation schedules to inflate a company's profit projections, it's essential to ensure the values presented are realistic and defendable. This calculation provides a clearer picture of a company's overall operational efficiency and the extent of its projections.
An example of EBITDA calculation
Here's a simplified EBITDA calculation example using the formula:
Let's say for company XYZ the given financials are:
Net income: $922,251 Interest paid: $103,900 Depreciation: $145,000 Amortization: None Taxes paid: $31,250
Here we are starting our EBITDA calculation with net income. The taxes detailed here include all paid sales taxes as well. So, the formula would be: EBITDA = Net income + Interest + Taxes + Depreciation + Amortization
Plugging in the numbers, we get: EBITDA = $922,251 + $103,900 + $31,250 + $145,000 = $1,202,401
So, the EBITDA for XYZ Co. according to this example would be $1,202,401. This value represents the company's earnings before interest, taxes, depreciation, and amortization are deducted, providing a clearer picture of its core operational profitability.
Interestingly, this figure is also an essential element when calculating the Debt to EBITDA ratio. This ratio helps prospective buyers or investors to understand company's capacity to pay off its liabilities, including sales taxes and debts. By dividing XYZ Co.’s total liabilities by its calculated EBITDA of $1,202,401, we can calculate this crucial ratio.
Understanding the Pros and Cons
Businesses worldwide find benefit in calculating EBITDA. If you're planning to incorporate it into your quarterly accounting, consider its benefits and potential drawbacks. Take a look at the top pros and cons below:
| Pros | Cons |
| Eliminates unhelpful variables | Can be inaccurate |
| Shows the benefit behind a company’s cash flow | May limit companies on their ability to secure loans |
| Provides a realistic image of business growth and expansion | Doesn’t acknowledge a variety of costs |
| No transfer of debts | Hides financial burdens |
| Commonly used | Capital expenditure is excluded |
| Easy to calculate | |
| Reliable |
An EBITDA calculation is neutral to capital structure, reducing the risk of variables influenced by capital investment and other financial details—a benchmark for business efficiency. By determining your EBITDA, you gain a comprehensive understanding of ongoing operational performance due to the general company cash flow, a major factor in distinguishing business leaders and potential laggards performing due to overall cash flow. It also casts light on growth prospects and the efficacy of your current business model.
However, not all is rosy. EBITDA calculations exclude a company's debt expenses, which can sometimes mask financial shortcomings, a considerable drawback. Securing a loan can become tricky based on EBITDA as it is computed based on actual financial performance—not considering factors like compensation litigation expenses. Depreciation and amortization costs, needed for adequately assessing a business' financial performance, aren't compensated either. Lastly, high-interest financial burdens aren't revealed with EBITDA calculations.
The benefits of EBITDA
EBITDA brings a host of benefits to owners, stakeholders, investors, and analysts. This profitability measure, in essence, clearly reflects the operational efficiency of a business, offering insights about comparative profitability across companies and industries. Adjusted EBITDA normalizes this metric depending on a company’s revenue and expenses. Therefore, it provides a transparent indication of a company's earnings.
- EBITDA serves as a standardized language understood by professional buyers, private equity investors, and advisors. It's often used as an alternate term for cash flow. EBITDA facilitates valuation estimations for a company using the EBITDA multiple, hence revealing details about agreed-upon transactions.
- When businesses are inspected as an investment, EBITDA grants an in-depth view into the performance of a business. It minimizes the confusion created by distinct accounting policies, tax strategies, and capital structures. This feature provides a clearer perspective on a business's capacity to generate profit. However, it's crucial to not overreach in pursuit of the highest EBITDA figure. Implementing guidance from trusted advisors or M&A specialists is essential.
- To many business owners, investors, and advisors' surprise, EBITDA offers a more comprehensive understanding of profitability and growth trends when the cost of capital, too, is removed from the equation. But remember that even though EBITDA calculations may seem similar, they can differ significantly across businesses. Consequently, be cautious while drawing comparisons to ensure you are not mistakenly comparing apples to oranges.
Limitations and arguments against EBITDA
EBITDA, while a valuable metric, should not be viewed in isolation. It has its distinct limitations, much like compensation and payroll systems, not to mention intellectual property aspects such as copyrights and patents that may expire and could significantly affect a company's financial health. The renowned Warren Buffet, CEO of Berkshire Hathaway, once criticized EBITDA as he did with inadequate market compensation strategies by saying , "References to EBITDA make us shudder – does management think the tooth fairy pays for capital expenditures?" Here are some of the key arguments against using EBITDA as a sole financial measure:
- Overlooking important expenses: EBITDA disregards costs related to depreciation and amortization. For instance, your company might record a considerable amount of depreciation of office equipment or bear the burden of amortization on software development costs and patents. Proponents argue that these are real costs impacting payroll and profoundly affecting the profitability and business value. Ignoring these can spark an overly optimistic compensation landscape.
- Not considering changes in working capital: EBITDA fails to factor in changes in networking capital, which can have a significant impact on a company's financial health and overall business value, and alter market compensation strategies.
- Can be manipulated: The formula, much like payroll systems, is susceptible to manipulation by companies aiming to make their financial performance appear better than it really is. This is why reexamination of the financials using independent calculations is necessary to avoid misleading figures and present a more accurate picture to potential buyers.
- Not a GAAP measurement: Although EBITDA is widely used, it's not a recognized measurement under the Generally Accepted Accounting Principles (GAAP). Consequently, some businesses prefer to use GAAP-recognized measures for their financial analysis, business valuation, and compensation decisions.
Despite these prohibitions, many companies and investors continue to find value in EBITDA as part of a comprehensive analysis of a company's financial health when used in conjunction with other measures. Thus, it's essential to be aware of its limitations to use it effectively and avoid misleading interpretations. A reexamination of these limitations, considering crucial elements such as company patents and other intellectual properties, often yields a clearer and more realistic evaluation of the company's worth.
Strategies to increase EBITDA
Improving EBITDA can make your company more attractive to potential investors and shareholders. Here are some strategies that can help in increasing your EBITDA:
- Stabilize Prices: Avoid unnecessary price reductions. Empower your customers with knowledge of the value your products/services offer, and charge appropriately, keeping in mind the sales taxes associated with your goods.
- Cut Expenses: Identify areas where expenses can be minimized without compromising the quality of the goods or services offered. Reducing costs, including the upkeep of liabilities such as machinery, can directly improve your EBITDA.
- Increase Revenue: Find ways to drive more sales and increase your company’s overall revenue. This could involve launching new products/services, expanding into new markets, or introducing donation models to augment revenue. Donations can significantly increase income without the necessity for stock depletion or service discharge.
- Streamline Inventory Management: Effective management of inventory, including tangible assets like machinery, can reduce costs and improve profit margins. Avoid overstocking and optimize order frequency and quantity to reduce holding and ordering costs.
- Recast Financials: Business owners can recast their company’s financials to make the EBITDA more attractive. This might involve adjusting one-time expenses, owner salaries, and other discretionary expenses, including depreciating machinery.
Remember, EBITDA is not the only financial measurement to consider. While it can provide useful insights about a company's financial position, it does not offer a full financial scope. Make sure to contemplate other vital financial metrics like cash flow, net income, and balance sheet items, specifically focusing on liabilities, to help make thorough business decisions.
Adjusted EBITDA and its implications
Adjusted EBITDA makes adjustments to the EBITDA calculation to remove irregularities and one-time costs that might distort the company's ongoing profitability.
For example, these irregularities could encapsulate expenses from unnecessary assets, such as if a company decides to annually rent a retreat centre in New York for team-building activities. Adjustments might also include one-time, non-recurring or unusual expenses such as restructuring charges, litigation, major repairs, or equipment replacements. However, adjusted EBITDA can serve as a proxy for cash flow, painting a more lucid image of a company’s financial health.
The philosophy behind this financial concept is to provide a more realistic view of the company's regular, ongoing operations, in compliance with the rules dictated by the jurisdiction. Upon careful examination, the adjusted EBITDA figure can serve as a more appropriate basis for comparison among different companies as it removes the impact of different accounting practices and various types of expenses incurred by different firms. This makes it an effective proxy for determining profitability in a way that transcends the complexities of varying business models.
But, critics of EBITDA and Adjusted EBITDA argue that it opens up for too much subjective interpretation, making it easier for companies to present an overly positive business performance. There could also be cases where the company pays more or less than the market rates, such as rent when the building is personally owned by one of the partners.
Therefore, it's crucial to use this financial proxy wisely, understanding the specific elements that are being included or excluded to derive the adjusted EBITDA for meaningful interpretation. In the interest of finding the best performance indicators, the adjusted EBITDA should also be interpreted alongside other financial metrics to get a comprehensive understanding of a company's health.
The Role of EBITDA in Business Evaluation
How EBITDA is used in business valuation
When valuing a business, EBITDA serves as a quick measure of a company's operating performance and cash flow potential. EBITDA allows potential buyers to see the company’s earnings potential without the influence of non-operating expenses like interest and taxes, offering significant aid during the due diligence stage. Business seller Tom Allen emphasizes the significance of understanding how a company's EBITDA affects its value, stating that it's not just an indicator of financial health but also a factor that can influence buyer consent and buyout decisions.
In Daniel Gordon's '32 Businesses Sold in 2022 Generating $619 Million in Liquidity for Our Clients,' Allen cautions against having preconceived notions of who the eventual buyer might be, reminding sellers that due diligence can uncover any inconsistencies.
EBITDA, a commonly utilized metric in business valuations dating back to the height of the leveraged buyout era in the 1980s, provides a clear picture of your business's financial performance. Businesses, valuators, bankers, analysts, and more compare a company’s financial performance to industry peers with EBITDA, using it as a key tool in gauging profitability before non-core expenses and charges.
EBITDA and enterprise value
In financial analysis, the enterprise value (EV) to EBITDA ratio is commonly used to determine the value of a company. To complement this analysis, you could also calculate the EBITDA coverage ratio to assess your company’s ability to cover its interest expenses with operating earnings. Here's the formula for EBITDA Coverage Ratio: EBITDA / Interest Expenses. A higher EBITDA Coverage Ratio suggests that the company has robust financial health. This ratio serves as a useful benchmark for comparing your business stability with competitors.
To calculate the EBITDA multiple, you first need to know your company's enterprise value (EV). The formula is as follows:
Enterprise Value (EV) = Market capitalization + Value of debt + Minority interest + Preferred shares - Cash and cash equivalents (bank accounts, marketable securities, treasury bills, etc.)
Subsequently, you can deduce the EBITDA multiple using this formula:
EBITDA Multiple = Enterprise Value / EBITDA
This ratio is used to compare the EBITDA (company’s cash earnings less non-cash expenses) to the overall value of a company. Often paralleled to the price to earnings (P/E) ratio, the EBITDA multiple can either point to a potential overvaluation (high ratio) or undervaluation (low ratio) of the company. Nevertheless, this is contingent upon industry norms and specific factors impacting the business.
When calculating EV and EBITDA multiple, bear in mind that these are merely some of the factors to incorporate for a comprehensive overview of your company's value. For additional guidance with financial assessments such as these, don't hesitate to contact our expert team.
EBITDA Frequently Asked Questions
What is a good EBITDA margin?
A good EBITDA margin varies considerably by industry. Being a pertinent profitability measure, EBITDA margin denotes a company's operational profitability as a percentage of its total revenue. As a universally accepted evaluation tool, it's widely used by analysts to compare the performance of companies and industries, achieving a higher level of comparability. Higher margins typically imply that a company is more financially robust and stable.
However, the concept of a 'good' EBITDA margin is subjective and depends on factors such as the industry, the size of the business, and the business model. Small companies, perhaps mastering the art of operational efficiency, may present a higher margin. In contrast, large-scale enterprises might exhibit lower EBITDA margins due to economies of scale, yet their sheer volume of operations could compensate for this.
CSIMarket provided a reference, indicating that from 2005 to Q1 2021, the average EBITDA margin for the S&P 500 was approximately 16%. To gauge what would be a profitable EBITDA margin for a specific company, compare it with industry peers or the market average.
Moreover, compensate for the limitations of the EBITDA margin by analyzing a variety of economic indicators, remembering that it's only one component contributing to the bigger picture of a company's profitability and overall health. It's also worth noting that compensation litigation expenses can affect a company's EBITDA margin, so it's important to factor these in when assessing a company's profitability.
How can EBITDA impact business loans?
In business financing, EBITDA plays a significant role in determining a company's ability to repay its debts. Banks frequently leverage EBITDA in their projections, assessing the creditworthiness of potential borrowers. These loan agreements often include EBITDA-centric financial covenants, obligating the borrower to maintain a minimum level of EBITDA to attest financial health and the capacity to repay the loan. Lenders see EBITDA as an invaluable tool for monitoring the borrower's operational performance and assessing potential risks that may impinge on loan repayment.
For instance, continuously falling below the obligatory EBITDA level might prompt default events with unforeseen ramifications for the borrower, such as escalating borrowing costs or extra collateral demands. Conversely, a higher EBITDA value may mirror a healthier, more lucrative business able to comfortably service its debts, potentially leading to more propitious loan conditions. One should be aware of the manipulation of EBITDA by varying depreciation schedules which can inflate a company's profit projections — EBITDA doesn’t mull over essential elements contributing to a company’s financial standing including copyright preservations and assets losing value over time.
However, businesses should bear in mind that EBITDA is merely one cog in the lender's decision-making machinery. Other elements such as credit rating, collateral, and the overall health and growth potential of the business also count as significant considerations for lenders. It's recommended to consult with financial experts to present figures that are practical, reliable, and defendable.
The Bottom Line
A thorough understanding of EBITDA is vital for business valuation – especially if you're gearing up to sell. Buyers and investors commonly utilize the EBITDA formula, often relying on an online template, to determine your company's potential and overall value, which is why you need to understand it.
If your accounting software doesn't include an EBITDA report, don't worry, you can use sites like Corporate Finance Institute, Spreadsheet Shoppe, or Stoneridge Partners for a suitable template. EBITDA results may fluctuate quarterly or annually depending on how effective your existing processes are. If you're already preparing to sell your company, taking time to learn about EBITDA and other crucial aspects of valuing and selling a business is highly recommended.
