August 12, 2024
If you’re thinking about selling your mid-sized business now or in the near future, understanding key financial metrics is paramount for assessing your company’s true worth. Two metrics that play a crucial role in this process are EBITDA (earnings before interest, taxes, depreciation, and amortization) and free cash flow.
In this guide, we break down the details of these two key metrics, including their significance in mid-sized business valuation, and how they paint a comprehensive picture of a company’s financial health and performance.
EBITDA, often referred to as the “operating profit” metric, strips away non-operating expenses such as interest, taxes, depreciation, and amortization from a company’s earnings to focus solely on its core operating performance.
By excluding these expenses, EBITDA provides a clearer picture of a company’s ability to generate profits from its primary business activities, independent of capital structure and accounting practices.
More on how to calculate EBITDA and why it’s important when selling your business here.
EBITDA serves as a key valuation metric for mid-sized businesses due to its simplicity and focus on operational efficiency. By normalizing earnings and removing non-operating factors, EBITDA allows investors, buyers, and analysts to compare the financial performance of companies across different industries and capital structures.
Additionally, EBITDA serves as a proxy for cash flow from operations, providing insights into a company’s ability to generate sustainable earnings and service its debt obligations.
In business valuations, EBITDA is often used as a basis for applying valuation multiples, such as the EBITDA multiple or EV/EBITDA ratio, to determine the enterprise value of a business.
In a nutshell: EBITDA is typically the main financial metric that potential buyers and investors look at when considering whether to merge with or acquire a mid-sized business, because EBITDA tells an investor/buyer how efficiently the company operates and how much of its earnings are attributed to operations.
Free cash flow (FCF) represents the cash generated by a company’s operations after accounting for the capital expenditures necessary to maintain or expand its asset base. It reflects the amount of cash available to shareholders and creditors after reinvesting in the business.
Free cash flow is a critical metric in mid-sized business valuation as it provides a measure of the company’s ability to generate cash that can be used for various purposes, such as debt repayment, dividend distributions, or reinvestment in growth opportunities.
Unlike accounting profits, which may be subject to manipulation or accrual accounting adjustments, free cash flow offers a more tangible measure of financial performance.
In valuation, free cash flow is often discounted back to its present value using an appropriate discount rate to determine the intrinsic value of a business. Additionally, free cash flow analysis helps assess the company’s financial flexibility, liquidity, and ability to withstand economic downturns or capital market disruptions.
While EBITDA and free cash flow both offer valuable insights into a company’s financial performance, they are not mutually exclusive. In fact, these metrics are often used in conjunction to provide a comprehensive assessment of a company’s value.
EBITDA serves as a starting point for assessing operating profitability and is often adjusted to reflect changes in working capital, capital expenditures, and other non-operating items to derive a measure of free cash flow. By integrating EBITDA and free cash flow analysis, stakeholders can gain a deeper understanding of a company’s earnings quality, capital allocation decisions, and long-term value creation potential.
It’s important to bear in mind, too, that EBITDA and free cash flow are not the only financial metrics that a potential investor/buyer may look at when considering whether to invest in or acquire your business. For example, an investor/buyer may also look at the company’s net income (read more on the difference between EBITDA and net income here).
Ultimately, EBITDA and free cash flow are indispensable tools in mid-sized business valuations, offering valuable insights into a company’s operating performance, cash generation capabilities, and intrinsic value. By understanding the nuances of these metrics and their relevance in business valuations, stakeholders can make informed decisions, identify growth opportunities, and maximize shareholder value.
Whether assessing investment opportunities, negotiating mergers and acquisitions, or evaluating strategic alternatives, a thorough grasp of EBITDA and free cash flow is essential for unlocking the true worth of a mid-sized business.
Interested to know what your company’s value would be if you decided to sell today? Woodbridge International offers free business valuations to companies with an annual revenue of $5 million-plus? Click here to claim your obligation-free valuation.