March 26, 2023 by Jacques de Muelenaere
We will start with the basics: EBITDA stands for Earnings Before Interest Taxes Depreciation and Amortisation.
Why is it important? EBITDA has long been used by potential investors to compare companies on an apples-to-apples basis. Essentially it removes the impact of non-operating factors such as taxes, cost of borrowing and amortization.
EBITDA is not part of GAAP and is generally not found on the financial statements of companies. So knowing how it is calculated is important to understanding your business and what it could be worth. Commonly, in negotiations for sale of your business, the buyer might express the offer price as a multiple of EBITDA (for example five times EBITDA). Please note, depending on the type of business and maturity of the business, EBITDA won’t always be a good metric. For example, a SAAS business in early growth stages might be valued at a multiple of recurring revenue and some businesses may be valued at the market value of the invested capital
Although EBITDA isn’t always applicable, it is important to know how to calculate it. Let’s look at a practical example:
Imagine you are looking to acquire a business and are comparing two options. Business A and Business B are identical in every way: Both have been in business for the same amount of time, same market share, manufacture the exact same widget in the same geographic area. Both generate $250,000 of gross profit annually. In their first year of business, both businesses required machinery that costs $100,000 to manufacture their widgets.
Company A decided to lease the machinery over the 5 years. Company B decided to purchase the machinery and finance it over 3 years. Using this handy online calculator, and some basic assumptions2, let’s compare how these different decisions would affect their respective financial Statements 1:
If just comparing After-Tax Income and Cash Flow, Company A looks like a much better investment. But Company B owns an income-producing asset. Additionally, Company A still has two years’ worth of lease payments to incur. This is not reflected if only focusing on Income and cash flow.
But if we calculate the EBITDA, it tells a different story:
Based on EBITDA, Company B is a better investment and reflects the better financial position that Company B is in. This is a crude example but hopefully one that demonstrates the difference between EBITDA and income or cash flow.
This is important addition to the EBITDA calculation. Once EBITDA has been calculated it sometimes makes sense to adjust it. The seller of the business would like to adjust it higher, and the buyer would like it lower. But the adjustments would need to be justified and the buyer and seller would need to have an agreement on allowable adjustments. Once again, let’s look at a practical example:
Let’s say the seller owns the real estate and rents the business premises from themselves (typically a separate entity would own the real estate from the operating company). Sometimes it would make sense to have a higher-than-market rental rate between the two entities and sometimes lower. This would depend on the tax or income situation of either entity. Or maybe even the goal is to just rapidly pay off the real estate. The buyer would not expect to have to carry that extra burden or similarly expect the same discount in an arms length transaction. In that case the buyer would adjust the EBITDA to reflect fair, similar, market rates for a similar property in that area.
There are many reasons an adjustment could be justified: Maybe the seller was paying themselves a higher-than-expected salary, or conversely a minimal salary to maximize dividends instead. There might have been one time anomalies on the historical financial statements that don’t reflect the normal day-to-day running of the business, like an extraordinary bad debt in one year. Once again there must be an understanding between the buyer and seller on how to address these adjustments.