EBITDA: A Complete Guide

Now that I’ve explained how to normalize your financial statements, let’s go into more detail about the primary measure of cash flow that nearly all valuations are based on – EBITDA. It’s critical that you fully understand what EBITDA is and why it’s the most common metric used to value businesses in the middle market. 

EBITDA

With the notable exception of tech businesses, EBITDA is the most common measure of earnings for mid-sized companies and allows a buyer to quickly compare two companies for valuation purposes. Once you know the EBITDA of a business, you simply apply a multiple to arrive at the value. 

Here’s the strict definition of EBITDA:

EBITDA = Earnings (or Net Income) Before Interest (I) + Taxes (T) + Depreciation (D) + Amortization (A)

EBITDA measures the profitability from the core operations of a business before the impact of debt (interest), taxes, and non-cash expenses (depreciation and amortization). It eliminates the impact of financing (interest) and accounting decisions (depreciation and amortization), which can vary from business to business.

Here’s a description of each component of EBITDA:

• Earnings (E): This is the net income of the business after all operating expenses such as insurance, rent, and payroll have been paid.
• Before (B): Referring to “Earnings Before …”
• Interest (I): This includes interest from all debt financing, such as bank loans. Different companies have different capital structures and varying levels of debt, resulting in different interest payments. This results in varying net incomes. EBITDA allows you to easily compare two businesses while ignoring the capital structure of each business, which may change after the acquisition. In other words, EBITDA includes interest payments because interest payments discontinue post-acquisition in most cases, with a few rare exceptions.
• Taxes (T): This includes city, county, state, and federal income taxes. Income taxes vary based on a number of factors and are likely to change post-acquisition. As a result, EBITDA includes taxes in its calculation. Note: Only income taxes are added back; don’t add back sales or excise tax when calculating EBITDA.
• Depreciation (D): Depreciation is a non-cash expense. Methods of depreciation vary by company. Actual cash flow is based on real capital expenditures (CapEx), not depreciation; therefore, depreciation is also added back when calculating EBITDA.
• Amortization (A): Amortization is a non-cash expense and is the “write-down” of intangible assets, such as patents or trademarks.

Sample EBITDA Calculation
Net Income (Earnings, or “E”)	$3,000,000
Interest (I)	+$500,000
Taxes (T)	+500,000
Depreciation (D)	+500,000
Amortization (A)	+$500,000
EBITDA	$5,000,000

Why EBITDA?

There’s one primary reason buyers use EBITDA – to compare two businesses with one another quickly. Here are several additional reasons EBITDA is so commonly used:

• EBITDA facilitates comparisons: EBITDA is an approximate measure of the cash flow available to the buyer. The goal of calculating EBITDA is to facilitate an apples-to-apples comparison between businesses. EBITDA allows one to make comparisons across companies, whether they’re in the same industry or not. 
• EBITDA is a rough estimate of free cash flow: EBITDA is an estimate of the amount of cash flow available to pay back interest or debt and fund the purchase of new equipment, such as “capital expenditures.” Once EBITDA is calculated, buyers will dig deeper into a multitude of other factors to calculate other measures of cash flow and the multiple, such as the growth rate of the company, its gross margins, customer concentration, and dozens of additional financial and non-financial factors. 
• EBITDA is primarily used as a measure of earnings: EBITDA is useful when a buyer is initially evaluating a company as an acquisition target. Once a buyer digs deeper, they’ll use other more specific measures of earnings to assess your company and will make adjustments to account for interest payments and capital expenditures. 
• EBITDA is used in most valuation methods: For example, EBITDA is used to calculate the value of a business in several income-based valuation methods. It’s also used when evaluating comparable transactions to compare multiples among similar businesses that have recently sold.

Benefits of EBITDA 

There are both advantages and disadvantages to using EBITDA to value your business. The following are the benefits:

• Common Use: EBITDA is the most commonly used measure of earnings by buyers, sellers, investment bankers, M&A advisors, and many others to value companies in the middle market.
• Straightforward Calculations: EBITDA is simple to calculate and less prone to error, which facilitates more accurate comparisons.
• Eliminates Non-Operating Variables: EBITDA eliminates variables that may not impact the buyer post-acquisition, such as interest or taxes. It also removes non-cash expenses, such as depreciation and amortization, so buyers can make their own estimates regarding the amount of these expenses. They can then deduct the amount from cash flow based on when the money is actually expended, not when it’s deducted for tax purposes.
• Allows Comparison: Because EBITDA is commonly used and straightforward to calculate, it allows one to easily compare a business’s earnings with other businesses. This comparison also facilitates the use of comparable transactions to value a business.

Downsides of EBITDA

EBITDA is fallible and can present these shortcomings, as well:

• Rule of Thumb: EBITDA is a simple rule of thumb. Expect buyers to dig deeper into your financials than just calculating EBITDA. EBITDA isn’t a magic bullet – just because your business has a high EBITDA doesn’t necessarily mean it will be an attractive acquisition candidate to a buyer.
• Not an Accurate Measure of Cash Flow: EBITDA is not a wholly accurate measure of cash flow for a buyer post-acquisition for the following reasons:
  • Depreciation: Adding back depreciation for companies with significant depreciation and ongoing capital expenditures results in an inflated measure of earnings. EBITDA is misleading for companies with significant ongoing capital expenditures. 
  • Amortization: The same can be said for amortization, as in the case of companies with significant amortizable intellectual property, such as pharmaceutical companies. 
  • Working Capital: EBITDA ignores working capital needs by not accounting for working capital injections that might be required by the buyer, especially in the case of high-growth companies.
  • Taxes: EBITDA also ignores the impact of income taxes. Theoretically, a company in a non-taxable state such as South Dakota may be worth more than a company operating in a state with corporate income taxes. 

Deciding on the Base Year

An important consideration is determining which year the valuation should be based on. A valuation is normally based on the last full year’s EBITDA or the most recent twelve months – also called trailing twelve months (TTM). In other cases, a weighted average may be used if results are inconsistent from year to year and business cycles are longer and unpredictable. Some value may also be placed on projected current-year EBITDA if the growth rate is consistent and predictable. Some buyers may attempt to use an average of the last three years’ EBITDA, which can pull down your valuation if your business is growing from year to year.

If you want to increase the value of your business – focus first on increasing the EBITDA of your business and then on increasing your revenue.

How To Increase the Value of Your Business

While you shouldn’t ignore other factors, one of your most important objectives should be to increase EBITDA. Every dollar increase in EBITDA increases the value of your business by its multiple. 

For example, let’s say your business is likely to sell at a 5.0 multiple. If you increase your EBITDA by $1 million per year, you will have increased the value of your business by $5 million ($1 million x 5.0 multiple = $5 million).

There are only two direct ways to increase EBITDA:

1. Increase Revenue: 
   • The easiest way to increase revenue is to increase your prices because 100% of your price increase will fall to the bottom line, less any direct sales costs. For example, if your company currently generates $10 million per year in revenue, and you increase pricing by 5%, your EBITDA will increase by $500,000 per year ($10 million x 5% = $500,000), less any direct sales costs such as commissions. If your current EBITDA is $2 million, your EBITDA will increase by 25% (to $2.5 million from $2 million). In essence, a 5% rise in prices can increase your EBITDA by 25%. 
   • Other methods for increasing revenue primarily include creating new products or services or selling more of your existing products and services. But be careful before engaging in risky product development or marketing campaigns if you plan on selling in the next few years. Conservative buyers generally won’t allow you to make adjustments for any unsuccessful marketing campaigns or product launches when calculating EBITDA. I recommend sticking to low-risk methods of increasing your revenue if you plan to sell in the next three years, such as increasing your budget in predictable marketing campaigns with measurable returns. Avoid high-risk sales or marketing strategies such as hiring a new sales manager or launching a new marketing campaign in which you have no experience. These strategies can drain cash flow, decreasing EBITDA and therefore decreasing the value of your business.
2. Decrease Expenses: Decreasing your expenses is often easier than increasing revenue. Doing so also has the advantage of immediately impacting EBITDA and is less risky than attempting to increase revenue. The only caveat here is to not reduce expenses the buyer would view as unfavorable – for example, standard insurance premiums should be maintained, as should normal inventory levels.

Another alternative for increasing the value of your business is to increase its growth rate, so “projected EBITDA” is used to value your business instead of the “current year’s EBITDA.” The value of your business is normally based on its most recent 12-month EBITDA (TTM). But, if you’ve demonstrated strong, consistent growth, you may be able to negotiate a price based on some measure of projected EBITDA.

Conclusion

The starting point for all business valuations is first to normalize your financial statements to calculate EBITDA. Nearly all valuations in the middle market are based on EBITDA. But when it comes time to adjust your financial statements, there are several tips you should keep in mind. If you’re planning to sell your business in the near future, remember to:

• Minimize the number of adjustments several years before the sale.
• Ensure all adjustments are thoroughly documented.
• Be conservative when making adjustments.

The number one method for increasing the value of your business is to increase its EBITDA. The second method is to increase revenue. So, if you want to increase the value of your business – focus first on increasing the EBITDA of your business and then on increasing your revenue.