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 when measuring a company’s basic financial health and value. However, over the years, another measure has gained importance in quarterly reports and accounts: EBITDA. It is employed to analyze and compare 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. EBITDA measures the company’s overall financial performance. It is often used as an alternative to other metrics, including earnings, revenue, and income. Before we dive into what EBITDA signifies and how the numbers are employed, we will take a look at the key terms in the name: Interest, Taxes, Depreciation, and Amortization.

  • Interest: Include 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 in the region by the government and regulatory authorities.
  • Depreciation: An expense that indicates the reduction in the value of fixed company assets. It is a noncash expense that signifies asset value reduction.
  • Amortization: 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 gives a figure that clearly reflects the operating profitability of a business that can be compared with other companies by owners, investors, and stakeholders. It is for this reason that EBITDA is often preferred over other metrics when deciding which business is more attractive as part of a mergers and acquisition strategy.

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

EBITDA in Business Valuations

EBIT is one of the many EBITDA variations. 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 it a step further by removing and identifying depreciation and amortization expenses as well. Both EBIT and EBITDA come in handy to understand the bigger picture of a company’s value by breaking down different expenses and their impact on the business’s worth.

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), EBITAC (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 employ EBITDA and its variations to compare the valuation of different companies. On the other hand, business owners can benefit from EBITDA by using it to enhance their exit strategy and take numerous business decisions, particularly operating decisions.

EBITDA is also compared with Seller’s Discretionary Earnings (SDE) that is used to determine the historical cash flow of the business. Think of it as a recasting process that starts with net profit. The owner’s salary and noncash profits are then 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.

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

The information required for EBITDA calculation should be included in the company’s income statement. Here it is important to reiterate the importance of accurate results as inaccuracy can result in over or undervaluation of the business and 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.

Evaluating EBITDA Calculation

EBITDA calculation is merely the first step. The next step is to determine if the EBITDA you have calculated reflects a good and profitable standing or not. 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 us take 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 has an EBITDA of $650,000, with the total revenue amounting to $7,000,000. The resulting EBITDA margin is 9.3%.
  • Company B has an EBITDA of $600,000, with the total revenue amounting to $6,000,000. The resulting EBITDA margin is 10%.

Despite its higher EBITDA, Company A has a lower EBITDA margin as compared to Company B, indicating the 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 the lesser total revenue and smaller EBITDA.

EBITDA Coverage Ratio

The EBITDA coverage ratio is another measure to understand EBIDTA value. Think of it as a solvency ratio that measures the ability of a business 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, it indicates that 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 a comparison between different companies. Instead, it indicates the company’s performance independently.

Adjusted EBITDA

The distinctions between EBITDA and adjusted EBITDA are minor, but they are important to understand. Adjusted EBITDA, in essence, 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 any 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.

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

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 EBITDA of the company with the industry as a whole. 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 and goodwill impairments
  • Above market compensation for the owner (in private firms)
  • Assets write-downs
  • Gain or loss in foreign exchange

Companies typically determine Adjusted EBITDA on an annual basis for valuation analysis. However, businesses can also calculate Adjusted EBITDA on a quarterly basis for internal use or even monthly when anticipating a potential M&A transaction.

Why Is It Important to Calculate EBITDA?

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

It analyzes and compares profitability among companies and industries as it eliminates 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 the business value, assisting companies and individuals in making important 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. So, we will next take a look at what EBITDA multiple is and why it is important for businesses.

EBITDA Multiple

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

  • EBITDA Multiple = Enterprise Value / EBITDA   

Calculating Enterprise Value

As evident by the formula, the first step of working out the EBITDA multiple is to determine the company’s enterprise value. It can be calculated by determining the sum of the value of debt, minority interest, market capitalization, and preferred shares. Next, subtract the cash and cash equivalent, 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 EBITDA multiple is that it considers the company debt, which other multiples like Price to Earnings ratio (or P/E ratio) overlook. When preparing to market a business as part of the exit strategy, it is crucial for business owners to include EBITDA in the financial terms.

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 may want to include is income. There are two types of income to consider: Net Income and Operating Income.

Net Income & EBITDA

EBITDA indicates the company’s ability to make a consistent 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 step by further stripping these expenses, focusing solely on the company’s profitability. Nonetheless, both Operating income and EBITDA are important calculations that can be employed to value a business. Use operating income when the goal is to analyze the production efficiency of the company’s operations.

What Can You Do to Increase Company EBITDA?

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

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

Recasting EBITDA Value

Recasting can be described as the process of amending or re-releasing earning statements with specific intent. Here, the financial experts will go through company financials to reinsert any one-off expenses or earnings. The reexamination of the financials with the required adjustments will lead to a clearer and more promising picture of the business for potential buyers.

However, keep in mind that recasting is not the same as hindering the numbers to manipulate the buyers. It is not an opportunity to hide facts as any discrepancies will be uncovered during the due diligence process.

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 that 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 down the road as it reduces the historical EBITDA of the company.
  5. Non-Arms-Length Expenses & Revenue: It includes all payment transactions where the company paid an amount smaller or greater than the market rates. For example, imagine the business rents 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, as well as other financials, represents a fair and honest reflection of your business valuation.

EBITDA in Business Valuation: Benefits and Limitations

EBITDA presents significant benefits for business owners, stakeholders, investors, analysts, and buyers as it indicates the fair value of the company’s 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 why you may want to calculate company EBITDA and include it in the financials.

  • The use of EBITDA is widespread. It is commonly employed by different groups, including buyers and sellers worldwide. Therefore, diverse stakeholders can use EBITDA to compare various business valuations and make informed decisions.
  • EBITDA removes variables that are unique and 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.

Limitations of EBITDA

EBITDA places focus on baseline profitability by eliminating capital expenditure. While some see this as the greatest strength of EBITDA, others view it as a potential drawback. The reason is that EBITDA allows companies to subvert problem areas in their financial statements by ignoring expenditure. As a result, it may hide the risks associated with the company’s performance.

Secondly, EBITDA is not recognized by GAAP (Generally Accepted Accounting Principles). Therefore, companies are free to interpret the formula. Such flexibility in EBITDA calculation allows companies to veil certain issues that may later be picked up during due diligence. Therefore, it is advisable to always work with reliable financial experts.

Connect with us for more information regarding EBITDA calculations. We are a leading advisory firm geared towards helping our clients make the right decisions.

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