In our last post we covered some highlights of the business valuation process. That overview ended with the introduction of a commonly used metric known as Earnings Before Interest, Taxes, Depreciation and Amortization—or simply EBITDA. In this post, we take a closer look at EBITDA and how to use it in developing a more accurate indication of value for your business.
As its name implies, EBITDA provides a snapshot of your company’s earnings before deducting interest expenses, taxes on income, depreciation (on tangible property) and amortization (on intangible property). It enables you to estimate your earnings ability without introducing additional variables. But—and this is important—do not confuse earnings ability with free cash flow.
Free cash flow, the amount of your available operating capital, is different from EBITDA and calculating it is more complex. It takes into account items such as debt service (principal) or capital expenditures made from cash flow.
So why is EBITDA important? Well, for one thing: it’s an invaluable starting point to help determine the worth of your business. By eliminating the variables of interest, tax, depreciation and amortization, EBITDA can help “normalize” earnings. This enables you to better compare your business’ value within the industry, sector or against the competition.
Eliminating interest, for example, removes differences in how business may be capitalized. If you’re looking to sell your business, this helps potential buyers make a more meaningful comparison, as most prospective purchasers will have restructured debt and their interest will be different.
In this same way, EBITDA can also remove differences in depreciation. Some businesses have older, fully depreciated equipment while others have new equipment. The bottom line is that there can be a big difference in depreciation expenses. With EBTIDA, you can better account for that.
It is important to remember that EBITDA simply provides a good starting point for determining relative value. It must be adjusted based on specific company and industry conditions. The other important thing to keep in mind is that your EBITDA, by itself, doesn’t give you the entire picture. After all, you have to pay interest on your debt, taxes have to be paid and depreciation and amortization are simply the recognition of future expenses to replace assets.
What it can do, however, is provide a good foundation for a solid and accurate valuation of your business’ worth. Next Up: Adjustments to EBITDA – what factors can be used to modify our number.