What is EBITDA?
EBITDA stands for Earnings Before Interest Taxes Depreciation and Amortization. it is one tool in how to value a company and it is helpful in comparing company values as it is intended to neutralize the capital structure of a company. It is also a gauge for lenders to know if companies will be able to pay their future debt obligations.
Is EBITDA the Same as Cash Flow or Sellers Discretionary Earnings?
EBITDA, Cash Flow and SDE are not the same thing. EBITDA only serves as a proxy for pre-tax operational cash flow. It gives a sense of what cash flows might be expected to come out of the business. Since a company’s depreciation, amortization, debt, and tax profile can change as a result of a taxes, net working capital, distribution structures, etc. EBITDA merely attempts to remove those components from the picture. EBITDA is also a more standardized way for buyers to compare companies within their respective sectors.
What EBITDA effectively does is take the earnings of a company while not accounting for capital expenditures (capex), change in cash taxes, changes in net-working capital and the interest on a company’s debt. EBITDA removes the factors that distort a company’s profit from the equation. This is why even though EBITDA is not precisely cash flow or SDE, it can be considered a very good statistic to use as a proxy for performance.
How is EBITDA Calculated?
The calculation starts with EBIT - a company’s profit before interest and taxes which is a nice number because it indicates how much profit a company produces before it pays debt holders and its taxes. After taking EBIT and adding back the depreciation and amortization expenses, we get EBITDA. EBITDA has the benefit of being a number that is not affected by how much debt a company carries.
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 creates 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 assets such as equipment, amortization involves adding back expenses tied with intangible assets such as intellectual property or patents.
OK – so what is Adjusted EBITDA?
An adjusted EBITDA calculation takes into account certain items that have no bearing on a firm’s actual operational costs including non-recurring or one-time expenses. Due to the way private companies account for these items, the use of adjusted EBITDA is more typical of private deals.
Aside from distinctions in size, the items that are included in the adjusted EBITDA calculation vary for every company depending on its payment structure and expenses.
Using the adjusted EBITDA calculation, companies can take out an extraordinary item including one-time expenses such as litigation costs, private equity fees, non-working family members/ costs or other items that are not a factor that into a company’s ongoing expenses.
Keeping a simple (fewer adjustments) operation is a good rule of thumb for CEOs to remember — this means the less discretionary add-backs to EBITDA, the better it is for acquirer confidence.
Experts agree that EBITDA has limitations and should be taken in the context of other factors in the transaction. Buyers seriously interested in your company will also conduct in-depth due diligence processes to examine your company’s financials over a longer period of time.
Due Diligence Overview
The norm is for buyers to examine a minimum of three years of financial statements and tax returns to determine a target’s profitability trends.
Beyond this, buyers will look at a target company’s balance sheet history as a means of discovering existing or potential cash flow issues and structure.
Conducting a quality of earnings review by looking at three- to five- 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 a sense of a business’ predictability.
Through due diligence, investors are looking for growth and an indication of whether a company
Alternatives to EBITDA for Measuring Financial
Most industries use a combination of adjusted EBITDA and free cash flow to measure how companies are faring. However, although EBITDA has become a standard metric for financial performance, certain types of companies or industries have relied on other metrics for various reasons.
Buyers have taken these discrepancies in company cycles into account when calculating the price they want to pay for targets in these industries.
Aside from capex cycles, in some privately held situations, buyers do not use EBITDA, but develop a price as a multiple of a firm’s revenue.
For technology and services companies, for instance, a multiple of revenue is used because of limitations in their cash flow and EBITDA.
Buyers are concerned about revenue streams. Technology and services companies in particular measure performance through their growing customer lists. For these firms, the number of subscribers is a draw for investors — even if they cannot show strong EBITDA.
For banks and other financial institutions, they typically use a multiple based on the return on a company’s assets or book value. In this case, the financial industry is generally looking at the return on equity.
A different measurement known as EBITDAR is used for organizations with high rent costs such as restaurants and casinos. EBITDAR expands on EBITDA by including “R” for rents to provide a more accurate picture of a firm’s financial performance.