How does EBITDA work?

During negotiations in a deal, buyers and sellers look closely at several factors in order to agree on a price that properly captures a company’s value.

One of the closely examined metrics in this process is EBITDA, which is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization.  EBITDA is one factor used as a way to measure the performance of a company. EBITDA indicates whether a business is profitable by revealing the amount of its normal operational earnings. EBITDA is also a gauge for lenders to determine if a company will qualify for financing such as an SBA (Small Business Administration) loan allowing a buyer to borrow the capital needed in an acquisition.  However, while EBITDA provides a valuable snapshot of a point in time in a firm’s cycle, it does not necessarily provide the complete picture of a business’ true value or performance.  This is where the importance of working with an experienced and skilled Business Broker comes into play.

When a seller is considering the actual value of their company, EBITDA is often used to present the company’s financials in a way that makes the firm’s post-sale cash flow as attractive as possible to buyers.  Buyers commonly use EBITDA as a starting point to measure the enterprise value of the company.  In general, what a buyer pays for a company is a multiple of EBITDA.  These multiples vary greatly depending on the industry and many other factors.

“Is EBITDA the Same as Cash Flow?”

Many think of EBITDA as synonymous to a company’s cash flow, but is this really the case? EBITDA serves as a proxy for pre-tax operational cash flow. It gives a sense of what cash flow might be expected to come out of the business after the transaction for you, the buyer. Since a company’s depreciation, amortization, debt, and tax profile can change as a result of a deal, EBITDA removes those components from the picture. EBITDA is also a more standardized way for buyers to compare companies within their respective sectors.

EBITDA removes the factors that distort a company’s profit from the equation. This is why even though EBITDA is not precisely cash flow, it can, in certain circumstances, be considered the best proxy.

“How is EBITDA Calculated?”

It is this Business Broker’s opinion that the best metric starts with EBIT, a company’s profit before interest and taxes. This is a fastidious number because it indicates how much profit a company produces before it pays debt holders and taxes to the government.
After taking EBIT and adding back the depreciation and amortization expenses for the period, we get EBITDA. EBITDA has the benefit of being a number that is not affected by how much debt a company carries. However, this comparison is ideally used within the same industry because the depreciation and amortization part of EBITDA will differ across industries.

Depreciation expense is created when the cost of a long-term asset is divided and reported as an expense over a period of time. For instance, companies that are in capital intensive industries often have a lot of equipment on the books that create a significant depreciation expense. When this depreciation expense is added to EBIT, the resulting figure is significantly larger. By contrast, other industries will have little or no depreciation to add back, which means the two figures will be approximately the same value.

While depreciation relates to “real” assets such as equipment, amortization involves adding back expenses tied to intangible assets such as intellectual property or patents. An amortization expense is created when a cost of a patent, for instance, is divided over the length of the patent.

There are differences in companies’ multiples and earnings. When buying the assets of a company, the transactions are mostly on a cash-free and debt-free basis, with the debt being paid off at closing. In terms of cash flow, buyers look at non-cash items such as depreciation.

“The Limitations of EBITDA and the Due Diligence Process”

Experts agree that EBITDA has limitations and should be taken in the context of other factors in the transaction. As a buyer, you and your advisors will also conduct in-depth due diligence processes to examine the company’s financials over a longer period of time. This is essential for buyers to get a proper assessment of a business’s worth.

It is important to keep in mind that EBITDA is only the starting point and one consideration in the due diligence process. Effective due diligence should result in the discovery of all operational issues there are in the financial reporting and EBITDA. The due diligence process generally occurs after the terms of an offer are mutually agreed upon by both the buyer and the seller. Buyers normally examine a minimum of three years of financial statements and tax returns to determine a target’s profitability trends.

It is customary for a buyer to look at a firm’s tax returns and compare them to its financial accounting reports because these returns may tell something about the business’ expense structure as well as the quality of a company’s profitability that might not be apparent from the financial statements. Additionally, buyers should look at a target company’s balance sheet history as a means of discovering existing or potential cash flow issues. It is essential to keep in mind that the reported EBITDA is important, but is not, by any means, all that a buyer should consider when determining the value of a target acquisition.

Conducting a quality of earnings review by looking at three (sometimes more) years of EBITDA will allow buyers to see whether the metric has gone up or down or if it has shown consistency over that period. This gives an important sense of a business’ predictability.

Through due diligence, buyers and investors are looking for growth and an indication of whether a company will continue to grow in the future with an emphasis on consistency and quality of future earnings.

A savvy buyer will consider, among other factors, if EBITDA is consistently growing over time. Examining financials greater than three years old may be important especially when considering periods nearing an economic cycle. This will provide a good indication of performance. I am finding that companies that maintained predictable earnings or that had not declined during the recent economic downturn are particularly attractive to buyers.

EBITDA can be a reliable number that a buyer should not ignore. However, buyers need to use a variety of measurements when considering an acquisition, including testing for the quality of earnings as part of their due diligence.

EBITDA is an important consideration especially when comparing investments; it is not a catch-all metric that can completely capture a company’s worth. Many sellers become fixated on seemingly unrealistic multiples of earnings or multiples of EBITDA. This is especially true when intangibles are increasingly becoming a larger part of a company’s overall value. Intangibles are non-physical assets such as intellectual property (i.e. patents and trademarks) and brand recognition and goodwill. In the current acquisition environment, intangible assets are seeing a greater consideration this results in higher multiples than we have seen in recent history. It can add an extra layer of complexity when determining the value vs. price formula (another topic I will cover in a future article) for the buyer.

My main objective in writing this article is for you, the buyer, to consider that the total value of a company cannot be reduced to just one number such as EBITDA. There are many factors we must consider beyond just EBITDA during your acquisition journey, below are just a few that come to mind:

• Growth rates
• Size
• Intangibles
• Quality of earnings
• Intellectual property
• Barriers to entry
• Recurring revenue
• Customer concentration issues

These are just a few of the reasons why utilizing experienced advisors, especially a skilled Business Broker, is critical when engaging in any acquisition.