EBITDA, an acronym for “Earnings Before Interest, Taxes, Depreciation, and Amortization,” is a crucial metric that clarifies a company’s operational profitability by stripping out expenses that might be considered non-operational or non-recurring. When multiplied by a specific multiplier, this figure yields the business’s value – hence, the EBITDA Multiplier Method.
Understanding EBITDA
Before delving into how to calculate this number, it’s crucial to truly comprehend EBITDA’s essence and break it into more straightforward language. Most business owners can instantly provide these figures when asked about their company’s revenue and net profit. However, what truly interests banks, underwriters, and investors is EBITDA, a concept that frequently baffles business owners. EBITDA is an essential evaluation metric primarily because it filters out numerous distortions in net profit, offering a more standardized view of operational activities.
Interest
Interest payments on both short-term and long-term debts can differ among companies. These interest payments, reflected on the Income Statement, influence the net profit calculation. Imagine two companies in the same sector with identical operational profits. If one carries a significant debt and the other has minimal debt, their net profits will appear distinct. The focus shifts from the business’s debt strategy to its pure operational profitability by excluding interest expenses. Furthermore, since many business acquisitions are structured as asset purchases1, the acquiring business typically won’t inherit the debt and interest payments.
Taxes
Not every business entity is subject to taxation in the same way. For instance, LLC taxes are typically passed on to the members, while corporations are taxed at the corporate level. Moreover, some corporations may have tax liabilities or credits that carry over to subsequent years. Tax obligations can vary significantly among companies and from one year to the next. Taxes are added back to the net profit to standardize across companies, as tax payments appear on the income statement.
Depreciation
Depreciation refers to the reduction in the value of an asset over time due to wear and tear, natural deterioration, or obsolescence. For tangible assets, such as machinery, vehicles, and buildings, this decline in value is recognized over the asset’s useful life. The purpose is to slowly account for this expense over its lifespan rather than the year of its purchase. Depreciation is a non-cash expense, and depreciation rates vary significantly from company to company.
Amortization
Amortization is conceptually similar to depreciation, but it applies to intangible assets such as intellectual property. Specifically, it pertains to assets like patents, copyrights, and other forms of intellectual property that don’t possess an indefinite lifespan. Frequently, companies may not list intangible assets on their balance sheet. Therefore, for the EBITDA calculation, this amortization is added back to the earnings.
How to calculate EBITDA
To calculate EBITDA, you start with a company’s net income. From there, you’ll add back the interest expense, taxes, depreciation, and amortization. Each of these components can be found on a company’s income statement. Mathematically, the formula can be represented as:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
By focusing on the core operational aspects of a business, EBITDA provides a clearer picture of a company’s earning potential without the impact of financing decisions, tax jurisdictions, and non-cash expenses like depreciation and amortization.
Adjusted EBITDA
Adjusted EBITDA is a modification of the standard EBITDA metric, wherein certain items are added back or subtracted to give a clearer picture of the ongoing, core operating performance of a business. The adjustments made typically reflect one-time, irregular, or non-operational items that the company believes don’t represent its underlying operational performance.
Common adjustments to arrive at Adjusted EBITDA include:
- The owner used the business to pay for personal expenses.
- The owner’s salary from the business isn’t typical for the industry or position.
- If the owner uses a building they own for the business, the rent charged might not match what’s typical in the market.
- Unique expenses or profits that won’t happen again, like when selling equipment.
- Expenses the business will owe but hasn’t yet recorded, such as upcoming bonuses or unused vacation days for employees.
- Adjustments related to unfinished jobs or products, often termed as “Work In Progress” or W.I.P.
Summary
Understanding a company’s financial health goes beyond mere revenue and net profit figures. EBITDA and its derivative, Adjusted EBITDA, stand as critical metrics in this evaluation, highlighting a firm’s operational profitability by sifting out non-operational or irregular expenses. By excluding factors such as interest, taxes, depreciation, and amortization, EBITDA offers stakeholders – be it banks, underwriters, or investors – a standardized insight into a company’s core operational activities. Furthermore, Adjusted EBITDA refines this perspective, considering unique or non-recurring expenses, ensuring an even more precise view of a company’s ongoing performance. Ultimately, in the complex landscape of business valuations, these metrics serve as lighthouses, guiding stakeholders towards a clearer comprehension of a company’s true value and potential.
Footnotes
- If the value of a business is less than $50 million ↩︎