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Understanding EBITDA: A Guide to Calculating & Using It in Business Sales

March 31, 2023

How to Calculate EBITDA & Why it’s Important When Selling Your Business

If you’re planning to sell your business, these are probably the most important six letters you need to know and understand: EBITDA. That’s because EBITDA is the financial metric that buyers and private equity groups most commonly use to measure a company’s profitability and cash flow, therefore it can have a significant impact on the value of your business.

What is EBITDA and Why is it Important?

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s a financial metric that measures a company’s profitability and cash flow by looking at earnings before deducting certain expenses. EBITDA is important because it provides a clearer picture of a company’s financial health than traditional net income or profit margins. Or, more simply, EBITDA tells investors how efficiently a company operates and how much of its earnings are attributed to operations.

This is why EBITDA is a commonly used metric in business valuations, as it helps potential buyers understand how much cash a business generates and how much debt it can service.

“Working with banks and lenders as a business owner…that term EBITDA was always put out there. And it took me a while to understand what it meant and get my head around it. But at some point, somewhere, somehow, I managed to understand that when you hit a million in EBITDA, it is the point where buyers will start to look at a business. In that middle-market range, that means you’re coming to the point where you are now saleable”
– Daniel Gordon, LandCare Associates

How To Calculate EBITDA

Calculating EBITDA is relatively straightforward. Start with a company’s net income or profit, then add back in interest, taxes, depreciation, and amortization. The resulting number is the company’s EBITDA.

For example, if a company has a net income of $1 million, interest expenses of $100,000, taxes of $200,000, depreciation of $50,000, and amortization of $25,000, its EBITDA would be $1.375 million ($1 million + $100,000 + $200,000 + $50,000 + $25,000).

Using EBITDA in Business Valuations

EBITDA is a commonly used metric in business valuations because it provides a clear picture of a company’s financial performance. By adding back in certain expenses, EBITDA allows potential buyers to see the company’s earnings potential without the influence of non-operating expenses like interest and taxes. This can be particularly useful when comparing companies in different industries or with different capital structures.

‘Business seller Tom Allen emphasizes the need to know how to differentiate their company from its competition, understand how their EBITDA affects the value of the business, and cautions against having preconceived notions of who the eventual buyer might be’
– Daniel Gordon, ‘32 Businesses Sold in 2022 Generating $619 Million in Liquidity for Our Clients’

Limitations and Criticisms of EBITDA

While EBITDA is an important metric in business valuations, it’s important to be aware of its limitations.

For one, EBITDA is not a perfect metric and should be used in conjunction with other financial measures when evaluating your company’s financial health.

Additionally, EBITDA doesn’t take into account important factors like capital expenditures and working capital requirements, which can have a significant impact on a company’s financial health.

Now onto the major criticism of EBITDA: it can be manipulated by unscrupulous companies to make their financial performance appear better than it actually is. This is why buyers and private equity groups (PEGS) tend to transact via reputable mergers and acquisitions specialists. These firms will calculate a company’s EBITDA independently because their reputation, quite literally, depends on honest transactions!

Other Financial Metrics to Consider in Business Sales

While EBITDA is an important metric to consider in business sales, it’s not the only one. It’s important to evaluate a company’s financial health from multiple angles to get a complete picture of its value. Seasoned business buyers and private equity groups know this, and will therefore take into consideration other financial metrics, such as revenue growth, profit margins, cash flow, and return on investment.

Additionally, astute buyers will take non-financial factors like market trends, competition, and industry regulations into account when valuing a business.

Last but not least, a buyer’s vision for the company is the ultimate deciding factor because, as Woodbridge International Managing Director Don Krier puts it, “beauty is in the eyes of the beholder”.

“More than once we’ve had two businesses in the same industry with the exact same EBITDA calculation that have sold at totally different prices. One company may sell at six times EBITDA, while the other sells at seven times EBITDA,” notes Don. “The difference? The higher selling company had more growth opportunity and less risk due to factors such as less customer concentration, better management and stronger marketing capability.”

What All Business Buyers Want

While EBITDA is a crucial metric when determining a company’s market value, never forget the cardinal rule of mergers and acquisitions: all smart business buyers are, ultimately, buying for the future.

And this is where M&A experts come into play: the best M&A advisors will not only accurately calculate your company’s EBITDA, they will also work with you to showcase the features that will make your business attractive to potential buyers.