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Mergers & Acquisitions, Value Acceleration & Exit Planning

The Importance of the EBITDA Calculation in Business Valuation

Investors often focus on net income, revenue, and cash flow to measure a company’s financial health and value. However, another measure has gained importance in quarterly reports and accounts over the years: EBITDA. This measure analyzes and compares profitability between different corporations and industries. Read on to learn more about EBITDA calculation, evaluation, and limitations.

 

 

What is EBITDA?

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It measures the company’s overall financial performance and is often used as an alternative to other metrics, such as earnings, revenue, and income. Before discussing what EBITDA signifies and how the numbers are employed, we will examine the key terms: interest, taxes, depreciation, and amortization.

  • Interest includes business expenses caused by interest rates, including interest on loans by banks or third-party lenders.
  • Taxes comprise any federal income taxes and state or local taxes imposed by the government and regulatory authorities in the region.
  • Depreciation is an expense that indicates the reduced value of fixed company assets. It is a non-cash expense that signifies asset value reduction.
  •  Amortization is another noncash expense that involves the cost of intangible assets. It can be defined as a process that gradually writes off the initial cost of an asset.

EBITDA focuses on the financial outcome of operating decisions by eliminating the impact of non-operating management decisions, such as tax rates, interest expenses, and significant intangible assets.

Consequently, the measure reflects a business’s operating profitability, which owners, investors, and stakeholders can compare with other companies. For this reason, EBITDA is often preferred over other metrics when deciding which business is more attractive in a mergers and acquisition (M&A) strategy.

EBITDA may be calculated for a company’s accounting period. LTM (Last Twelve Months) EBITDA is a valuation metric representing all earnings before adjustments associated with interest, tax, depreciation, and amortization in the past 12 months. LTM EBITDA is also known as TTM (Trailing Twelve Months) EBITDA.

EBITDA excludes depreciation and amortization because these expenses are subjective, meaning their calculations can vary significantly between companies. This subjectivity arises from the difficulty of accurately estimating the useful life of tangible and intangible assets. Different depreciation and amortization methods can lead to varying expenses, impacting a company’s net income. By removing these subjective elements, EBITDA provides a more focused view of a company’s operational performance, highlighting its earnings from core activities.

 

EBITDA in Business Valuations

EBIT is one of the many variations of EBITDA. The main difference between EBIT and EBITDA is the number of steps taken to reach a relevant and meaningful value that helps owners and stakeholders make decisions based on the company’s financial health.

EBIT, or Earnings Before Interest and Tax, represents the value of earnings without the effect of tax rates and interest. EBITDA takes this further by removing and identifying depreciation and amortization expenses. By breaking down different expenses and their impact on a company’s worth, EBIT and EBITDA help us understand the bigger picture of its value.

In addition to EBIT, there are several other variations of EBITDA, including EBIAT (Earnings Before Interest After Tax), EBIDA (Earnings Before Interest, Depreciation, and Amortization), EBITDAR (Earnings Before Interest, Tax, Depreciation, Amortization, and Restructuring/Rent Costs), EBITDAC (Earnings Before Interest, Taxes, Depreciation, Amortization, and Coronavirus) and more. All values help build a picture of the company’s value.

Potential buyers and investors generally use EBITDA and its variations to compare the valuations of different companies. On the other hand, business owners can benefit from EBITDA by enhancing their exit strategy and making numerous business decisions, particularly operating decisions.

EBITDA is also compared with Seller’s Discretionary Earnings (SDE), which determines the business’s historical cash flow. Think of it as a recasting process that starts with net profit. The owner’s salary and non-cash profits are added to the net profit. SDE is similar to EBITDA. The main difference that settles the EBITDA vs. SDE debate relates to the size of the business. EBITDA is generally employed for larger corporations and organizations, whereas SDE is more suitable for smaller companies.

In essence, private equity firms prefer EBITDA because it removes financial variables that could skew comparisons, allowing for a more transparent evaluation of a company’s core business performance. This standardization is crucial when making investment decisions or valuing potential acquisitions across an industry. By focusing on EBITDA, investors can more accurately gauge the company’s potential for growth and profitability, regardless of its capital structure or tax environment.

 

How is EBITDA Used in Financial Modeling?

EBITDA plays a crucial role in financial modeling. It is often a foundational metric for calculating unleveraged free cash flow.

 

Key Uses of EBITDA in Financial Models

Starting Point for Cash Flow Analysis
EBITDA is typically utilized as a baseline for generating cash flow projections. This is because it strips away the effects of financial decisions, such as debt structure and non-cash accounting factors, providing a clearer picture of operational profitability.

Benchmark for Valuation
While discounted cash flow (DCF) models value a business by focusing on free cash flows, EBITDA is a reference point that analysts often use to compare companies within the same industry. Its ability to standardize earnings makes it easier to assess relative value.

Performance Measurement
EBITDA offers insight into a company’s operational performance, independent of its capital structure or tax situation. It is a popular metric for investors and analysts to evaluate a company’s underlying performance by excluding interest, taxes, depreciation, and amortization.

Simplified Profit Assessment
For many, EBITDA provides a simplified snapshot of a company’s earnings potential without the noise of financial and accounting decisions. This makes it a go-to metric for quick assessments and comparisons.

 

EBITDA Calculation: How to Calculate EBITDA

Accurate EBITDA calculation is a key part of the overall company valuation. Accountants employ two formulas to calculate the EBITDA value:

  • EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortization
  • EBITDA = Operating Income + Depreciation + Amortization

Both formulas ultimately provide the same outcome through different methods. The first formula starts from the net profit and adds back interest, taxes, depreciation, and amortization, making it comprehensive for understanding all adjustments. The second formula begins with operating income and focuses on adding non-cash charges, which might be more straightforward depending on the available financial statement data.

The information required for EBITDA calculation should be included in the company’s income statement. Here, it is essential to reiterate the importance of accurate results, as inaccuracy can result in overvaluation or undervaluation of the business and the company’s profitability. Therefore, it is advisable to invest in a reliable accounting system or consider working with experienced and trusted accountants when keeping your financials up to date to ensure accurate EBITDA analysis.

Incorporating these formulas into your financial review process gives a clearer picture of operating performance, stripping away non-operational expenses and non-cash charges. This clarity is crucial for potential investors or stakeholders assessing the company’s core earnings capacity.

 

Evaluating EBITDA Calculation

EBITDA calculation is merely the first step. The next step is determining if your calculated EBITDA reflects a good and profitable standing. Companies employ different measures to evaluate their EBITDA calculation and derive meaningful information. These measures include the following:

 

EBITDA Margin

EBITDA margin determines the percentage of calculated EBITDA against the overall revenue generated by the company. The goal is to determine the amount of cash profit that a company makes in a year. If the EBITDA margin of a company is greater than the EBITDA margin of other businesses, it indicates that the company has greater growth potential. The formula used to calculate the EBITDA margin is as follows:

EBITDA Margin = Calculated EBITDA / Total Revenue

Let’s look at an example to understand how businesses calculate and use EBITDA margin. Suppose that two companies calculate their EBITDA margins based on their respective EBITDA and total revenue as follows:

  • Company A’s EBITDA is $650,000, and its total revenue is $7,000,000. The resulting EBITDA margin is 9.3%.
  • Company B’s EBITDA is $600,000, and its total revenue is $6,000,000. The resulting EBITDA margin is 10%.

Despite its higher EBITDA, Company A has a lower EBITDA margin than Company B, indicating higher growth potential and a more promising future than Company B. Based on these results, analysts, potential buyers, investors, and business owners weighing different options will find Company B to be a more lucrative option regardless of its lesser total revenue and smaller EBITDA.

 

EBITDA Coverage Ratio

The EBITDA coverage ratio is another measure of EBITDA value. It is a solvency ratio that measures a business’s ability to pay off its liabilities associated with leases and debts using EBITDA.

After the EBITDA calculation, you can derive the EBITDA coverage ratio by dividing the sum of lease payments and EBITDA by the sum of principal and interest (debt) payments and lease payments. The formula used to calculate the EBITDA coverage ratio is as follows:

  • EBITDA Coverage Ratio: (EBITDA + Lease Payments)/ (Interest Payments + Principal Payments + Lease Payments)

When the resulting value is greater than 1, the company is in a strong position to pay off its liabilities, debts, and other obligations. As a result, it may be an attractive option for investors and potential buyers.

Businesses calculate the EBITDA coverage ratio because, unlike the EBITDA margin, this measure is not based on comparing different companies. Instead, it indicates the company’s independent performance.

 

Adjusted EBITDA

The distinctions between EBITDA and adjusted EBITDA are minor but important to understand. Adjusted EBITDA normalizes this metric depending on a company’s revenue and expenses. These can differ significantly among businesses, making it difficult for analysts and buyers to assess whether one is more enticing than another.

By standardizing cash flows and income and removing anomalies, such as owner bonuses, redundant assets, rent paid above market value, etc., Adjusted EBITDA enables people to analyze multiple enterprises at once, regardless of variances in industry, geography, or other factors. However, several additional considerations should be made when comparing EBITDA ratios between companies to ensure an accurate evaluation.

 

Industry Comparison

It is crucial to compare companies within the same industry. Different industries have vastly different average EBITDA ratios. For instance, high-growth industries tend to exhibit higher ratios, while low-growth sectors often display lower ones.

Operational Alignment is also important to ensure companies have similar operations and customer bases. This alignment helps provide a consistent benchmark.

 

Financial Metrics

Look at the margins and growth rates of the companies. Identical or similar financial dynamics are essential for a fair comparison. A high Enterprise Value/EBITDA ratio may suggest an overvalued company, while a low ratio might indicate undervaluation.

Considering these factors makes adjusted EBITDA even more powerful for evaluating companies. This comprehensive approach allows investors to make informed decisions by understanding the numbers and their context.

 

Other Irregularities

Accountants use any of the basic EBITDA formulas discussed above to calculate adjusted EBITDA. However, before this step, removing the costs associated with various irregular and one-time expenses that do not impact daily business operations is crucial.

Standardizing EBITDA gives an adjusted or normalized EBITDA value that is easier to compare for different companies than EBITDA. It also allows businesses and individuals to compare the company’s EBITDA with the industry. Here is a list of common EBITDA adjustments:

  • Non-operating income
  • Noncash expenses
  • Unrealized loss or gain
  • Single-time loss or gain
  • Litigation expense
  • Donations
  • Goodwill impairments
  • Above market compensation for the owner (in private firms)
  • Assets write down
  • Gain or loss in foreign exchange

Companies typically determine Adjusted EBITDA on an annual basis for valuation analysis. This approach provides a comprehensive view of financial performance over a longer period, which can be crucial for making strategic decisions.

However, businesses can also calculate Adjusted EBITDA every quarter for internal use. This practice helps monitor performance trends more frequently and adjust strategies as needed.

Companies may calculate EBITDA monthly for even more immediate insights. This is particularly useful when anticipating a potential M&A transaction, as it provides a more detailed and up-to-date financial picture.

  • Monthly Calculations: Offers granularity, which is especially valuable in dynamic situations like M&A.
  • Quarterly Calculations: Useful for regular performance reviews and strategic adjustments.
  • Annual Calculations: Provides a broad overview for valuation and long-term planning.

By leveraging these different time frames, companies can better tailor their financial analysis to suit their specific needs and objectives.

 

Why Is It Important to Calculate EBITDA?

Understanding EBITDA calculation and evaluation is important for business owners for two main reasons. First, EBITDA provides a clear idea of the company’s value. Second, it demonstrates the company’s worth to potential buyers and investors, painting a picture of its growth opportunities.

It analyzes and compares profitability among companies and industries, eliminating the impacts of financing, government, and other accounting decisions to provide a raw indication of earnings. Therefore, it is readily used by owners, buyers, private equity investors, and analysts worldwide. It is an important standout formula that provides an overview of business value, assisting companies and individuals in making crucial business decisions. It can also be used as an alternative for cash flow.

Moreover, the EBITDA multiple can provide an estimated valuation range for the company.

When using EBITDA for business valuation, several factors should be considered to ensure an accurate assessment:

Industry Context: Different industries have distinct average EBITDA ratios influenced by growth dynamics. High-growth industries typically exhibit higher ratios, making comparing companies within the same sector essential.

Operational Similarity: Comparisons should be made between companies with similar operations, customers, and margins. This ensures that the valuation reflects the business’s performance rather than external market conditions.

Growth Rates: Understanding a company’s growth rate is crucial, as it can affect the perceived value. High-growth companies may justify higher valuations due to future profit potential.

Overvaluation vs. Undervaluation: By comparing a company’s EBITDA ratio to industry averages, investors can determine whether it is overvalued or undervalued, guiding informed investment decisions.

Incorporating these considerations allows for a more nuanced and reliable use of the EBITDA metric, ensuring that it is a robust tool for valuing businesses across diverse industries.

 

EBITDA Multiple

An EBITDA multiple is a ratio that compares the annual EBITDA with the company’s overall enterprise value (EV). Like several other EBITDA variations, it determines and compares a company’s value with similar businesses. The formula used to calculate the EBITDA multiple is as follows.

  • EBITDA Multiple = Enterprise Value / EBITDA

 

Calculating Enterprise Value

As the formula demonstrates, determining the company’s enterprise value is the first step in calculating the EBITDA multiple. However, enterprise value is only applicable to public companies. Still, private companies can benefit from this calculation by applying it to publicly traded peer companies to infer an approximate EBITDA multiple for their business.

Determining a company’s enterprise value can be calculated by determining the sum of debt, minority interest, market capitalization, and preferred shares. Next, subtract the cash and cash equivalents, including marketable securities, bank accounts, treasury bills, etc.
The formula for calculating Enterprise value is:

  • Enterprise Value = (Market Capitalization + Value of Debt + Minority Interest + Preferred Shares) – (Cash & Cash Equivalents)

Once you have calculated the Enterprise value, divide it by the company’s EBITDA to find the EV/EBITDA Multiple ratio. It indicates if the company’s value is under or over-stated. A high ratio shows that the company value might be overstated, while a low ratio may indicate that the company is undervalued.

One benefit of using the EBITDA multiple is that it considers the company debt, which other multiples like the Price to Earnings ratio (or P/E ratio) overlook. Business owners must include EBITDA in the financial terms when preparing to market a business as part of the exit strategy.

The goal is to speak the language of the buyer. In other words, use terms and measures that they are familiar with. Since EBITDA is widely accepted worldwide, it can help owners provide potential buyers with valuable insights into the business. Another measure that you should include is income. There are two types of income to consider: Net Income and Operating Income.

 

Net Income & EBITDA

EBITDA indicates a company’s ability to consistently profit, while net income indicates a company’s total earnings. Net income is generally used to identify the value of earnings for every share of the business. It can be calculated using the following formula.

  • Net Income = Revenue – Business Expense

 

Operating Income & EBITDA

Operating income can be defined as the profit after removing the company’s operating expenses, including amortization and depreciation. An operating expense is an ongoing cost of running a business. It can be calculated using the following formula.

  • Operating Income = Revenue – Cost of Goods Sold – Operating Expenses

EBITDA takes it to the next level by removing these expenses and focusing solely on the company’s profitability. Nonetheless, Operating income and EBITDA are important calculations that can be employed to value a business. Operating income is used to analyze the production efficiency of the company’s operations.

 

What Can You Do to Increase Company EBITDA?

When presenting their company’s financials to exit the business, company owners strive to present EBITDA and other statistics dating back at least 3 to 5 years. This data shows how the company has grown, telling purchasers that the potential for continuing growth is good.

Higher EBITDA indicates better company performance. Therefore, business owners can improve the company’s EBITDA to make the company more attractive to potential buyers and investors. This can be achieved by recasting company financials.

 

Recasting EBITDA Value

Recasting is the process of amending or re-releasing earning statements with specific intent. The financial experts will review company financials to reinsert any one-off expenses or earnings. Reexamining the financials with the required adjustments will lead to a more precise and promising business picture for potential buyers.

Recasting is not the same as hindering the numbers to manipulate buyers. It is not an opportunity to hide facts, as discrepancies will be uncovered during due diligence.

Several aspects of previously published statements can be re-casted to enhance the EBITDA of a company to present a more accurate and relevant picture of its value. Here are some of the aspects you may want to recast.

  1. Expenses or Revenue from Non-Essential Assets: Buyers may not recognize expenses or revenue associated with unnecessary assets. For example, imagine that you rent a property in the country for a corporate retreat every year. A potential buyer may not recognize this cost.
  2. One-Time Fees: Buyers are more interested in learning about the ongoing costs they will incur once they take over. Therefore, if you spent money on a one-time marketing campaign or litigation, these costs do not represent the ongoing costs the buyer would have to take on.
  3. Owner’s Salary & Bonuses: Owner salaries and bonuses are typically higher than employee salaries and benefits. However, the owner’s salary and bonuses may vary depending on the owner. Therefore, this is not a cost that the buyer must follow.
  4. Repair & Maintenance Expense: Business owners often categorize capital expenses as repair or maintenance costs to bring down taxes. However, it is important to understand that this practice may hurt the company’s valuation as it reduces its historical EBITDA.
  5. Non-Arms-Length Expenses & Revenue: This category includes all payment transactions in which the company paid an amount smaller or greater than the market rate. For example, imagine a business renting a building owned by one of the partners for a price lower than the market value. Such costs must be adjusted to reflect the right market value, as the buyer is unlikely to maintain the same values.

These are the five key areas that companies can adjust to increase the EBITDA and provide a better view of the business to potential buyers. However, make sure that EBITDA and other financials represent a fair and honest reflection of your business valuation.

 

EBITDA in Business Valuation: Benefits and Limitations

EBITDA significantly benefits business owners, stakeholders, investors, analysts, and buyers by indicating the company’s fair value. However, there is room for exploitation, which may lead to undesired consequences in the long run for all parties involved.

 

Benefits of EBITDA

Here are some reasons you may want to calculate company EBITDA and include it in the financials.

  • The use of EBITDA is widespread. Different groups, including buyers and sellers worldwide, commonly employ it. Therefore, diverse stakeholders can use EBITDA to compare various business valuations and make informed decisions.
  • EBITDA removes unique variables that vary from business to business. It includes tax rates, interest rates, depreciation, and amortization. This approach provides an accurate representation of the company’s operating performance.
  • EBITDA is easy to calculate and evaluate. The calculations are rather straightforward and provide highly valuable information.
  • Finally, EBITDA is a reliable business valuation metric that allows buyers to focus on the baseline profitability of the company.

 

Why Do Some Investors Criticize EBITDA?

Many investors express skepticism towards EBITDA for several key reasons:

  1. Lack of Recognition by Accounting Standards: EBITDA is not a metric recognized by standard accounting practices like GAAP or IFRS. This lack of formal endorsement raises concerns about its reliability and the consistency of its application across different companies.
  2. Overly Optimistic Financial Picture: By focusing solely on earnings before interest, taxes, and non-cash deductions, EBITDA can paint an overly positive picture of a company’s financial health. It ignores the costs of debt (interest) and taxes, which are crucial elements of real-world business operations.
  3. Omission of Depreciation and Capital Expenditures: EBITDA does not account for depreciation, which represents the natural wear and tear on assets over time. Similarly, it overlooks capital expenditures, the funds used to sustain or expand a company’s asset base. This omission can inflate the perceived profitability, as it does not reflect necessary spending to maintain or enhance assets.
  4. Potential for Misleading Comparisons: Companies might have vastly different debt levels or face different tax rates. By omitting these key elements, EBITDA can make disparate companies appear comparable when, in reality, their financial situations are quite different.
  5. Lack of Cash Flow Insight: Since EBITDA excludes the cash outflows for taxes and interest, it does not provide an accurate picture of a company’s cash generation ability, a crucial aspect of assessing operational health.

In summary, while EBITDA can offer a quick snapshot of operating performance, its exclusions, and optimistic nature lead many investors to approach it cautiously, seeking a fuller picture through more comprehensive financial metrics.

Connect with Windes for more information about EBITDA calculations. We are a leading advisory firm that helps our clients make the right decisions.

 

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