Potential buyers typically focus on a company’s cash flow, revenue, and net income when measuring its value and financial standing. However, another metric has become a common way to track and compare profitability between companies and sectors: EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization). Here, we will explain EBITDA calculations and their importance in business sales. Defending your EBITDA will be important.
EBITDA: What Is It?
EBITDA is an abbreviation for earnings before interest, taxes, depreciation, and amortization. Often used in place of revenue, income, and earnings, it’s a measure of a company’s financial performance. Before discussing how owners may justify EBITDA when putting their companies up for sale, we will describe the terms that make up the acronym.
- Earnings are the net income that a company brings in during each reporting period.
- Interest includes interest rate-related expenses, including interest on bank and third-party loans.
- Taxes include those assessed at the local, state, and federal levels.
- Depreciation is any expense that signifies the declining value of a fixed asset.
- Amortization is a non-cash expense related to the cost of a company’s intangible assets.
A company’s EBITDA is related to the financial effects of its operating decisions, as non-operational factors like interest expenses, intangible assets, and tax rates are not considered. EBITDA gives potential buyers a clear picture of a business’ profitability. Therefore, it’s used more often than other measurements when choosing businesses as part of an acquisition strategy.
Different Types of EBITDA
In the merger and acquisition world, there are three EBITDA categories: normal, adjusted, and pro-forma. Becoming familiar with these types will allow sellers to maximize their companies’ value to potential buyers.
- Normal EBITDA is a simple measurement; it’s an as-is consideration of a company’s numbers.
- Adjusted EBITDA is a bit more complex. It considers non-recurring expenses as well as those listed in the wrong reporting period. For instance, if a company automates its processes, it may lay off some employees, giving them a severance package. Those packages are a sizable expense that will lower a business’ EBITDA for the period. However, the metric will return to its normal level when that one-time expense is added back into the earnings column.
- Pro-forma EBITDA is another adjustment that accounts for things that haven’t happened yet. A good example comes when a service business signs a contract halfway through the fiscal year. While this year will only bring six months of revenue, the next year will be fully covered. Then, the owner can adjust the company’s EBITDA upward and make it more compelling to potential buyers.
Now that we’ve explained what EBITDA is and how it affects a company’s daily operations, we will delve into the benefits and drawbacks of this metric as they pertain to business sales.
How Business Owners Can Use EBITDA to Their Advantage When Selling
EBITDA is a sign of how well a company manages its daily operations, including key expenses such as goods and materials. It’s a reliable way to assess a business’ current and potential states, and in some instances, it’s more accurate than net income or gross profit.
While gross profit shows how much money is coming in after factoring in a company’s cost of goods, it doesn’t show how much is left after expenses are paid. Net income does, but it’s affected by numerous outside factors. For example, if the government can’t balance its own budget, it may raise taxes. There’s no way around it for any business, but the effects on net income are inevitable.
The higher a company’s EBITDA is, the more easily it can endure tax hikes, sales slumps, and other challenges—and the better it will look to potential buyers. By working with a business sales specialist, any owner can paint his or her company in a more favorable light.
The Potential Negative Effects of EBITDA
While EBITDA is an important metric, it doesn’t tell the full financial story of a business. Debt is a key part of EBITDA calculations, and companies paying high interest rates may find themselves at greater risk when the market changes. In the case of variable-rate debt, those rates will increase every time the Federal Reserve raises its rate. Those effects will, at some point, trickle down to customers, creating cash flow problems and putting an owner in a tough spot should they decide to sell. EBITDA, although a proxy for cash flow, is not actual cash flow. It does not consider capital expenditures, especially the bad kind of capital expenditures, maintenance ‘capex’. Having an expert M&A advisor or business broker who has experience and who is skilled in defending your EBITDA is a must, as buyers will find ways to attack your EBITDa and lower their purchase price.
What Do Business Buyers Look for When Considering a Company’s EBITDA?
In growing and thriving companies, an adjusted EBITDA figure will almost always be higher than its normal EBITDA, and pro-forma numbers will exceed both. When selling a company, an owner should aim for a valuation that’s based on the highest number possible, but within reason. Keeping track of constant adjustments can be tough, however. Every company’s situation is different, and owners should consider working with accountants to arrive at a precise EBITDA before putting their businesses up for sale.
Although EBITDA is a crucial part of a pre-sale valuation, it’s not the only criterion by which companies are judged. Potential buyers and investors also consider customer concentration, the diversity of revenue streams, past performance during economic downturns, and other factors.
Aside from performance metrics, business buyers also look at companies’ culture, leadership, and sector growth rates. Numerous factors go into a business valuation, and defending your EBITDA is just as important as every other factor. That’s why it’s so important to know what it is, how it functions, and how to use it to position a company for a successful sale.
Explain a Company’s EBITDA and Make it More Appealing to Buyers
By learning more about EBITDA and striving to improve it before selling, an owner will show that they know the company’s real value and are serious about selling. When EBITDA is fully documented, it’s easier to get a high valuation and a better sale price. The world of mergers and acquisitions is a competitive one indeed, and we are here to give your company an edge. Defending your EBITDA is a must to protect your purchase price. Contact CGK Business Sales by phone or use our online form to schedule a consultation with an experienced business broker.