EBITDA

EBITDA is an acronym representing Earnings Before Interest Taxes Depreciation (and)
Amortization. It is the most widely used "income" metric to estimate the value of a business. The formula is EBITDA times a multiple, which equates to the expected sale price of a company. This formula is well-understood as a rule of thumb among investment bankers and company executives. However, as explained in this article, it usually does not represent cash flow.

The "multiple" portion of the equation is developed from an analysis of sales transactions of similarly sized companies in a particular industry or market segment. Market data is often difficult to verify or lacking; thus, multiples are usually stated as a range or a median within a range.

This discussion is more focused on what EBITDA does not include and why it is not cash flow. Recognition of the four elements discussed below will result in a Pro Forma EBITDA, and much closer to real cash flow.

1. Capital expenditures – unrecognized, significant outlays for equipment and facilities (capex) can reflect higher EBITDAs.
2. Depreciation – elongating the depreciable lives of assets can understate depreciation and inflate EBITDA.
3. Working Capital – Probably the most misunderstood aspect of cash flow analysis, subject to varying interpretations, is required working capital for daily operations. There is no specific formula for each company, so each firm must be analyzed in isolation. Key factors are the cash needs (number of months to be covered) to balance purchases and labor costs against revenue cycles. The higher the working capital, the lower the EBITDA.
4. Capital leases – the International Accounting Standards Board (IASB) is almost certain to require that all leases be capitalized. All assets and liabilities arising from leases will be recognized on the balance sheet. EBITDA will change, usually increasing in the early years based upon amortization using the effective interest method. Also, EBITDA will increase now that the operating lease expense is replaced by two components not now in EBITDA: interest and depreciation.