EBITDA: What is it and why does it matter?
The use of EBITDA is one of the most widely used metrics to understand the financial performance of a company. The acronym stands for Earnings Before Interest Taxes Depreciation and Amortization. EBITDA allows the financial world to adjust for certain transactions and arrive at a uniform measure of how well a business enterprise is doing. Anyone considering the sale of their business should be keeping an eye on EBITDA, understand exactly how its calculated and the impact it will have on the value of their company.
How is it calculated?
EBITDA is widely accepted to mean cash flow from operations. While EBITDA ignores working capital requirements and capital investment, which we will cover in another post, it provides a quick and widely used measure of just how well a firm is doing. The EBITDA calculation is effective for a buyer as a measure of true cash flow from a business as it ignores certain accounting adjustments, tax payments, and the effect of a Company’s debt burden.
The calculation is as follows:
Net Profit
Plus
Interest
Taxes
Depreciation
Amortization
= EBITDA
Remember, EBITDA is a measure of cash flow, and it is generally measured on a debt free basis. Thus, interest is removed from the calculation to measure the cash flow from the business before payment of long term debt. Taxes are also removed as different industries and firms have varying tax environments and may be calculated differently by different owners. EBITDA adjusts for these variations. Non-cash accounting adjustments such as Depreciation and Amortization are eliminated as they are used to spread over time the life of certain assets and as such is susceptible to inconsistent judgment between firms. By removing these items and “normalizing” cash flow, EBITDA improves the ability to compare firms to one another.
What is it used for?
EBITDA is a general measure of cash from operations and is important in assessing the performance of the firm over time compared to industry benchmarks. As such it is a key valuation measure for developing the sale price or valuation of a business. Understanding the change in EBITDA over a period of time facilitates an understanding of the underlying value and cash flow of any business, which is obviously imperative in evaluating potential acquisitions. As a commonly used indicator for research firms, EBITDA benchmarks are often published for specific industries that allow an outsider to discern on average how a firm is performing relative to its peers. As indicated above, however, EBITDA is most widely used as a primary tool in measuring a company’s value, which is typically expressed as a “multiple of EBITDA.” A company with EBITDA of $250,000 and a valuation of $1,000,000, is said to be selling at 4 times EBITDA. Practically, this means the company is worth 4 times its cash flow from operations. Determining the multiple is a topic for another post, but needless to say both the calculation of EBITDA and the determination of the multiple are heavily negotiated business terms that should be understood by all parties to a transaction.
