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.
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.
Noted below are elements which most impact EBITDA. These adjustments are made to reflect the true earnings potential of the company, and to eliminate any one-time or non-recurring expenses. Sellers should carefully consider these adjustments to support the highest amount.
- Capital Expenditures – unrecognized, significant outlays for equipment and facilities (capex) can reflect higher EBITDAs.
- Working Capital – probably the most misunderstood aspect is the 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.
- Capital Leases – the International Accounting Standards Board (IASB) requires that certain 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 included in EBITDA: interest and depreciation.
- Real Estate - owned outside the business. Below market rent paid by the company will increase EBITDA.
- Personal Expenses - paid by the company (e.g. entertainment, life insurance, legal advice, etc.) should be added back to EBITDA.
- Owners Compensation/Benefits – in addition to normalizing the owner’s compensation to reflect “industry norms,” salary and benefits paid to family members not active in the business should be added back.
- Inventory Adjustments – inventory adjustments: this includes any write-downs or write-offs of inventory, which can impact the company’s earnings.