Do you know what your company earns before taxes, interest, depreciation and amortization? If you don’t know, or it would take time to get to the exact number, your potential buyer or banker has the upper hand in any negotiation! You need to know your EBITDA number so you can create a narrative around why it is what it is. Without that narrative, you do not have any type of leverage and the buyer doesn’t have the full story.
What is EBITDA?
EBITDA stands for Earnings Before Interest Taxes Depreciation and Amortization and is usually synonymous with a company’s pre-tax operational cash flow. If you were to transfer your company to someone else, what is the “transferable value” that it has to another party?
For bankers, traders, analysts, and business buyers, a company’s EBITDA number it is usually the benchmark for how healthy a business is, how easily it can service any future debt, and an indicator of how much to value the future performance of the firm.
In plain English: How much available cash flow do you have coming into the business? Yes, we need the accounting reclassification that applies certain profits and expenses to different categories for various reasons… but the BASIC question is… how much money comes in the door each month that is available to the owner of the business?
Check out this Investopedia video and definition HERE
How is it calculated?
Take the company’s Net Profit + Interest + Taxes + Depreciation + Amortization. Begin with EBIT… a company’s profits before interest and taxes which reflects how much a company makes before it pays it’s debt and profits to the government. Depreciation and amortization are then added back in to create EBITDA.
Why are interest, depreciation, and amortization removed?
Depreciation and amortization are both calculated differently for every company and across industries. The calculation differs depending on how businesses account for their equipment and intellectual property.
A potential buyer may have a different corporate structure, tax bracket, and debt load, so buying your business under YOUR current structure wouldn’t apply. They would have to migrate your company into THEIR structure (depending on the type of purchase).
For example, if you were to buy a house from someone, would you care what they had left on their loan, the length of the loan, what they were paying for interest, or how they were depreciating it?
That is exactly the same perspective a buyer has on your business. They don’t care how you’ve structured your current situation, only how they will benefit from the price they pay and how much they can make off of it based on their setup, connections, and potential future growth of the business.
Why does EBITDA matter?
EBITDA is good indicator of how healthy a company is. EBITDA reflects the business’s financials and is a great indication of how much the company’s cash flow is worth to a potential buyer. Banks use a company’s EBITDA to determine how much money they can loan a business and if that company is healthy enough to service the loan without getting into trouble. A buyer looks at the EBITDA and determines a multiple (a certain number of years it will multiply the EBITDA by) in order to acquire (or buy that cash flow) from the owner.
What happens if an event impacts your EBITDA?
Did you have a lawsuit, random client refund, or out of the blue environmental situation that impacted your pre-tax income?
Don’t worry about how a one-time event like this can change your valuation. Business buyers know that these are common situations and can account for them. This scenario is what is known as an “add-back”, and the process of getting to a true EBITDA number is called a “normalized EBITDA”. Whether it is you OR the potential buyer, the goal is to figure out how much money your company really makes.
Buyers, bankers, and YOU should be concerned with what “normal” looks like and what to expect in the future. Yes, there are going to be things that pop up and hit the balance sheet but that is BUSINESS! The goal is to know what events are repeat offenders and how to predict and account for them in the future. As the business owner, you want to be able to budget for planned and potentially unplanned expenses, and as the potential buyer, you would want to know what expenses to expect in the future if/when taking on the responsibilities of the company.
EBITDA is not the only gold standard for valuation or company health
There are many factors that go into the perceived health of a company. Determining a company’s future potential does not always depend on the current EBITDA. Your company is worth what someone is willing to pay for it. There are many situations and countless variables that can add to (or detract from) your company value… here are just a few:
- Growth factor
- Intellectual property or patents
- Size / client base
- Barriers to entry
- Recurring revenue
- Reliance on working capital
- Client concentration
Bottom line:
Know your numbers, why they are what they are, and how to incorporate or explain them in your company story to your banks or buyers.