The 2 Most Common Measures of Cash Flow

Now that we have explained why the range of values can be so wide for businesses, let’s explore the actual mechanics of valuing a business. But before we do, let’s take a deep dive into the two primary measures of cash flow that all valuations are based on for small to mid-sized businesses – earnings before interest, taxes, depreciation, and amortization (known as EBITDA) and seller’s discretionary earnings (known as SDE). All valuations are based on a measure of cash flow, so it’s critical that you understand how EBITDA and SDE are calculated and which measure of cash flow is right for your business. After I explain how EBITDA and SDE are calculated, I will walk you through the primary methods for valuing a business.

EBITDA

EBITDA is the most common measure of earnings for mid-sized companies. EBITDA 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 a value of the business. 

Here is 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 the 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.

Here is 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, payroll, etc., have been paid.
• Before (B): Referring to “Earnings Before” …
• Interest (I): This includes interest from all debt financing, such as loans provided by banks. 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 changes post-acquisition anyway. 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 based on the method of depreciation used. Actual cash flow is based on real capital expenditures, not depreciation; therefore, depreciation is also added back.
• Amortization (A): Amortization is a non-cash expense and is the “depreciation,” also technically called the “write-down,” of intangible assets such as patents or trademarks.

Here is a sample EBITDA calculation:

Net Income (Earnings, or “E”) = $700,000

EBITDA = Net Income (Earnings); plus …

Interest (I): $400,000; plus

Taxes (T): $300,000; plus 

Depreciation (D): $200,000; plus

Amortization (A): $100,000

EBITDA = $1,700,000

Seller’s Discretionary Earnings (SDE)

Seller’s discretionary earnings (SDE) is a measure of the earnings of a business and is the most common measure of cash flow used to value a small business. Once you know the SDE of a business, you apply a multiple to arrive at the value of the business. 

SDE is defined as pre-tax net income, plus …

• Owner’s compensation paid to all owners, less the cost needed to replace a second or third owner
• Interest expense
• Depreciation and amortization
• Discretionary expenses such as auto, cell phone, meals, entertainment, travel, etc.
• Adjustments for extraordinary, non-operating revenue or expenses, and non-recurring expenses or revenue such as from a lawsuit, flood damage, etc.

Here is a sample SDE Calculation:

Pre-Tax net income;	+ $300,000
Owner’s compensation;	+ $150,000
Interest;	+ $50,000
Depreciation;	+ $50,000
Amortization;	+ $50,000
Discretionary expenses;	+ $100,000
Extraordinary, non-operating, non-recurring expenses;	+ $50,000
Seller’s Discretionary Earnings (SDE)	= $750,000

What’s the difference between EBITDA and SDE?

EBITDA and SDE are two different methods of measuring the profit or cash flow of a business. The main difference is:

• EBITDA is the primary measure of cash flow used to value mid-to-large-sized businesses and does not include the owner’s salary as an adjustment.
• SDE is the primary measure of cash flow used to value small businesses and includes the owner’s salary as an adjustment. 

Why EBITDA and SDE?

There is one primary reason buyers use EBITDA and SDE – to quickly compare two businesses with one another. Keep these points in mind:

• Rules of Thumb: EBITDA and SDE are rules of thumb. They are approximate measures of cash flow available to the buyer. The goal of calculating EBITDA and SDE is to make an apples-to-apples comparison between businesses. EBITDA and SDE facilitates comparisons across companies, whether they are in the same industry or not. 
• Rough Estimate: These are just a rough estimate of the amount of free cash flow available to pay back interest or debt and fund the purchase of new equipment, such as “capital expenditures.” Once EBITDA and SDE are 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 hundreds of additional financial and non-financial factors. 
• Measure of Earnings: EBITDA and SDE are primarily used at the outset as a measure of earnings. They are useful when a buyer is initially evaluating a company as an acquisition target. Once a buyer digs deeper, they will use other more specific measures of earnings to assess the company and will make adjustments to account for interest payments and capital expenditures. 
• Multiple Uses: EBITDA and SDE are used both in income-based and market-based valuation methods. For example, EBITDA and SDE are used to calculate the value of a business using a multiple in several income-based valuation methods. They are also used to consider comparable transactions and compare multiples among similar businesses that recently sold.

Benefits of EBITDA and SDE

What are the benefits of EBITDA and SDE?

There are advantages and disadvantages to using EBITDA and SDE to value your business. Let’s first explore the benefits:

• Common Use: EBITDA and SDE are the most commonly used measures of earnings by buyers, sellers, investment bankers, M&A advisors, business brokers, and every other party to value small to mid-sized companies.
• Straightforward Calculations: EBITDA and SDE are simple to calculate and less prone to error, thereby facilitating comparisons.
• Eliminate Non-Operating Variables: EBITDA and SDE eliminate variables that may not impact the buyer post-acquisition, such as interest or taxes. They also remove 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 is deducted for tax purposes.
• Allow Comparison: Because EBITDA and SDE are commonly used and straightforward to calculate, they allow you 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 and SDE

EBITDA and SDA aren’t infallible. It’s important, therefore, to be aware of their shortcomings as well:

• Rules of Thumb: EBITDA and SDE are simple rules of thumb. Expect buyers to dig deeper into your financials than just calculating EBITDA or SDE. EBITDA and SDE are not magic bullets. Just because your business has a high EBITDA or SDE doesn’t necessarily mean that your business will be an attractive acquisition candidate to a buyer.
• Inaccurate Measure of Actual Cash Flow: EBITDA and SDE are not wholly accurate measures 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 and SDE are misleading for companies with significant fixed, depreciable assets. 
  • Amortization: The same can be said for amortization, as in the case of companies with significant amortizable intellectual property, such as pharmaceutical companies. However, this is less common.
  • Working Capital: EBITDA and SDE ignore 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 and SDE also ignore 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. However, this varies based on the tax strategy employed by the company.

Are EBITDA and SDE the same as cash flow? No, they are entirely different concepts. Your cash flow can be determined by your “cash flow statement” or “statement of cash flows.” Many small businesses, unfortunately, don’t prepare a cash flow statement. “Cash flow” as a term is used loosely in the industry and you should always ask for a definition whenever someone uses it.