Why Business Owners Should Understand EBITDA (Valuation Tips)

Share on facebook
Share on linkedin
Share on twitter

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. EBIT allows you to determine an earning value without the impact of interest and tax rates, while EBITDA identifies and removes any expenses related to depreciation and amortization. Many business owners find using both calculations beneficial as each allows you to gather a clear understanding of your company’s value, expenses, and impact. 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. However, net income outlines a company’s total earnings. The difference between the two shows that net income is utilized to figure out the value of your business’s earnings per share rather than its overall earning potential.

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 strips these operating expenses out entirely to gain a clear picture of a company’s profitability. Both EBITDA and operating income calculations help value your business since operating income can analyze the production efficiency of your company’s core operations and overall expense management.

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. Using an online EBITDA calculator can help if you’re not sure how to do this on your own. However, the basic EBITDA formula is listed below:

EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization

Understanding the Pros and Cons

Businesses worldwide find benefit in calculating EBITDA. If you’re planning to work it into your quarterly accounting, there are a few pros and cons that should be considered. 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, meaning the risk of variables affected by capital investment and other financing variables is significantly reduced. By determining your company’s EBITDA, you’ll have a clear idea of how ongoing operations are performing due to overall cash flow. EBITDA calculations also provide an overview of company growth opportunities and how well your current business model is performing.

A company’s debt expenses are excluded from an EBITDA calculation which can be misleading as failures and financial shortcomings can be hidden. It can also be challenging to secure a loan with an EBITDA calculation, as loan eligibility is calculated based on actual financial performance. Depreciation and amortization costs aren’t valued as they should be because these costs are needed to measure a company’s financial performance. Lastly, high-interest financial burdens aren’t revealed with EBITDA calculations.

Next Steps

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 to determine your company’s potential and overall value, which is why you need to understand it. 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.

Categories

Find the best loan for your small business. Compare, Choose and Save.