Why All Business Owners Should Understand EBITDA!
What Is EBITDA and How Does It Impact a Company’s Valuation? Before your eyes roll up into your head, take a few minutes to read this very important article! EBITDA is used to analyze a company’s operating profitability before non-operating expenses (such as interest and other non-core expenses) and non-cash charges (depreciation and amortization).
EBITDA stands for:
The basic purpose of this calculation is to improve the earnings comparability among companies. EBITDA offers a clearer reflection of operations by stripping out non-core, non-operational or non-recurring line items that can obscure a company’s true operating performance. In the calculation of EBITDA, interest, which is largely a function of management’s choice of financing, is adjusted. Income taxes are adjusted since pre-tax earnings are the primary driver of valuation and acquisition discussions. EBITDA removes the non-operating and often arbitrary factors that can go into calculating earnings. By eliminating these items, EBITDA makes it easier to evaluate the financial health of companies and compare or benchmark against industry averages. It also is useful for evaluating firms with different capital structures, tax rates, depreciation policies and unusual events. EBITDA is a good measure of the fundamental earning power of a company’s operations since it eliminates some of the extraneous factors and allows for a more “apples-to-apples” comparison with its peers.
Common Adjustments to EBITDA for Purposes of Valuing a Company:
When selling a privately held company, there are several common adjustments made to EBITDA. Adjustments of “onetime” charges that arguably are out of the ordinary course of business; therefore, they should be added back to estimate the company’s cash flow generation ability. The following is a list of some of the common adjustments made to calculate adjusted EBITDA:
Excess Owner Compensation
A common EBITDA adjustment is recalculating actual owner compensation to normalized owner compensation. Owner compensation is generally a discretionary number dictated by the Shareholder(s). The difference between the owner’s total compensation package and what the compensation cost would be to hire someone to replace the functions of that shareholder is often added back to EBITDA as excess owners’ compensation. For example, if a Shareholder was earning $150,000 and it was determined that the position can be replaced for $100,000, a $50,000 add-back would be made in the calculation of EBITDA.
This usually includes executive life and health insurance, medical benefits, and discretionary travel and auto expenses. Shareholder perks or fringe benefits that would not likely apply to an acquirer would need to be added-back, however,if these fringe benefits are expected to continue they should not be added back.
Depreciation and Amortization
These are deemed non-cash expenses. Accelerated depreciation methods can have a significant impact on a company’s taxable earnings. EBITDA requires making an adjustment for depreciation; however, a portion of this expense may require an offset to reflect anticipated capital expenditure requirements to maintain current equipment.
Examples are litigation expenses, moving expenses, leasehold improvements, start-ups of a new facility, or other unique expenses that would not occur in the future. These non-recurring expenses should be identified in calculating adjusted EBITDA since they likely will not be applicable going forward.
This refers to the cost to hire consulting, legal, and financial advisors for services that would generally not be required on a going forward basis.
This refers to charge-offs for unsaleable, obsolete, or damaged inventory. Other categories that are sometimes relevant include charitable donations, entertainment expenses, and bad debt expense. Timing adjustments can also apply if certain income or expenses were accounted for in one period but should have been in another period. It is important to appreciate that this type of analysis is a “mix of art and science”. Since companies are primarily valued based upon multiples of adjusted EBITDA, identification of appropriate adjustments can have a significant impact on business valuations.
Effects of EBITDA in Transactions:
In summary, sellers and buyers should familiarize themselves with the standard EBITDA calculations and adjustments. A transaction with an attractive multiple might not be a great deal for the seller if that multiple is not applied to an appropriately adjusted EBITDA figure. Similarly, a low multiple will not protect a buyer from a bad investment if the multiple is applied to an unrealistically optimistic measure of EBITDA. Rather than relying on rules of thumb, we encourage our clients to engage in a comprehensive valuation process that considers the market for the company, the entity’s earnings potential, the inherent risks and the -opportunities for growth associated with those earnings, the value of the company’s assets less liabilities, as well as other factors. There are approximately 60 different – adjustments to consider when analyzing a Company’s EBITDA. Sun Mergers & Acquisitions and Sun Business Valuations are well versed in the determination of the value of businesses and much of this analysis is influenced by the EBITDA adjustments that are described above. Please contact Stephen J. Goldberg at (201) 727-1300 or moc.regremnus@gs with any questions about the information above, or if you would like to discuss the valuation of your company.