It’s easy to calculate and yet can be a mystery, wrapped in a riddle, inside an enigma. It’s one of those acronyms that everyone pretends to understand but rarely has a solid handle on. Seems complex and complicated, but EBITDA calculations can be as difficult as they’re made to be, and its “adjusted” definition varies by source.
EBITDA is a critical component of core business profitability, performance, and most importantly valuation; a metric that business owners should understand and monitor regularly. Designed in the 1970s to determine industry industry-streamlined value of high growth/capital-intensive companies, the EBITDA concept is a business analytic blueprint constructed to measure profitability over a specified timeframe which gauges a company’s ability to repay potential debt financing.
Let’s define EBITDA:
Earnings Before Interest, Taxes, Depreciation, and Amortization
EBITDA fundamentally measures a company’s core operating performance beyond the impact of non-core fiscal expenses and removes unique variables that differ between every business. EBITDA does NOT account for non-operating expenses (interest on debt, taxes, other costs), but establishes baseline profitability metric by removing capital expenditures and taxation from net earnings.
Variances in Earnings
- Interest: Interest varies depending on the business geographic location, variable interest rates, market conditions when it raised capital, etc. which is inconsistent across all businesses even those in the same industry
- Taxes: Tax variations depend largely on company location and municipal and state related business tax exposures
- Amortization: Amortization expense is the method used to decrease intangible asset (i.e.: software, patents, customer lists) cost over their useful life
- Depreciation: Reduces the value of tangible assets over their useful life. Depreciation expense is a loss of an asset’s value over time; (i.e.: physical equipment, vehicles, forklifts, production equipment, etc.)
What it does
EBITDA calculations demonstrate a company’s ability to generate revenue and is a determinative measurement of a company’s core business operation. It establishes a consistently clean picture of profitability and provides a dedicated shortcut to understand available cash flow. EBITDA growth indicates gross profit increases, revenue growth, higher net earnings, etc. all while being a consistent KPI for business performance, profitability, and value while evaluating variables unique to a company’s operational decision making process such as depreciation, taxes, interest, and amortization costs.
In addition, an EBITDA calculation allows an investor or business owner to compare two companies in different locations with different nuanced metrics of location specific operational requirements and most importantly from a leveraged acquisition perspective, allows an owner, prospective buyer, and lender to understand a company’s ability to add and pay down debt.
When is it used
Investment bankers use EBITDA to calculate a company valuation or sale via acquisition. Variable multiples of EBITDA are applied based on the industry, current and historical market conditions, geographic location, business historical performance, and forecasted growth potential.
Bankers use EBITDA to calculate how much long term debt a company can pay from its cash flow (debt coverage ratio). In addition, banks use EBITDA calculations as debt covenants or as baseline debt coverage ratio requirements as loan conditions.
Adjusted EBITDA
Adjusted EBITDA is a normalized version of EBITDA which measures one-off, irregular, and non-recurring expenses. It removes anomalies to streamline industry comparisons. There are no standard list of adjustments which are meant to capture irregularities and non-standard business expenses, but see a list of potential adjustments to consider below:
- Discretionary expenses
- Non-cash losses
- Legal fees and settlements
- Insurance claims
- Above market rent factor
- One-time non-recurring expenses i.e.: extraordinary items)
- Owner’s w2 & bonuses
- Repair and maintenance expenses (should be depreciated over time, immediate tax write-off means it can’t be counted as an asset.
Shortcomings and Limitations
EBITDA is not a true picture of profitability. It doesn’t account for the distinct ways a company uses debt, equity, cash, or other capital sources to finance operations. It doesn’t always account for an individual business investment in heavy capital, intellectual property, major infrastructure improvements which may hide risk of inefficient or lost expenditures, nor does it provide insight into a company’s cash flow (earnings don’t = profit). In addition, it loses explanatory value by excluding important expenses such as net income, cash flow metrics, and foundational financial strength, all of which must be accounted for to understand a business’ fundamentals.
Why it matters
A good EBITDA margin is a relative concept and depends on industry specific metrics and the specific company’s unique operational approach. By excluding variables unique to a company’s operational decision making process, EBITDA tells investors how efficiently a company operates and what percentage of earnings come from operations.
Before taking your business to market, the S&P Capital Partners team produces a valuation to establish a fair market business “range of value. We apply several methodologies including an EBITDA calculation, cash flow analysis, historical trends assessment, and industry standards comparisons, etc. to establish a range of value based on those metrics. If you’d like more detail on EBITDA and the underlying nuances of business valuation, connect with the team at S&P Capital Partners today.
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