Business Funding Secrets
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EBITDA and Acquisitions


EBITDA is an acronym for earnings before interest, taxes, depreciation and amortization and is often used to measure the value of some businesses. It can also be used in the comparison of similar companies.

 

Generally, EBITDA makes it easier to evaluate various companies and to compare them against industry averages by removing the non-core and irregular operating costs, such as interest, which can vary depending on the management’s choice of financing, taxes which can fluctuate depending on acquisitions or losses from prior years, and arbitrary factors of depreciation and amortization.

 

The EBITDA formula can be used as a guideline when valuing larger companies, or when comparing the profitability of large similar companies in the same industry. For the effective use of EBITDA, these larger companies should possess significant assets, have heavy amortization schedules, or bear substantial amounts of debt. Considering small businesses don’t meet that criteria, the EBITDA formula is not a useful measure as the sole means for valuing small companies for acquisition purposes.

 

To Calculate EBITDA:


1. Calculate net income by obtaining total income and subtract total expenses.
2. Determine the total amount of taxes paid to federal, state, and local governments.
3. Compute interest fees paid to companies or individuals for the use of credit, or capital.
4. Establish the cost of depreciation (the expense recorded to allocate a tangible asset's cost over its useful life).
5. Determine the cost of amortization (the expense for consumption of the value of intangible assets, such as goodwill, patents, and copyrights, over a specific period of time, or the asset's expected life.
6. Add #1 through #5. 
   

EBITDA Sample:

Net Income
+ Taxes paid
+ Interest Expenses
+ Depreciation
+ Amortization
EBITDA =

 
1,000
300
200
100
50
1,650

 

During the 1980s EBITDA was being used as a proxy for cash flow in leveraged buyouts to calculate whether companies could service their debt. Factoring out interest, taxes, depreciation, and amortization can allow an unprofitable business to appear financially healthy. This method of valuation was used extensively during the dotcom era to value unprofitable businesses, with few assets, little earnings, and the results from that method caused many to go bust. This is a blaring example of misapplying EBITDA.
 
Drawbacks of EBITDA:
1. Can be misleading number when it is confused with cash flow.
2. Can make even completely unprofitable firms appear to be financially healthy.
3. Numbers are easy to manipulate.
4. Can overlook cash requirements for growth in accounts receivable.
5. Can miss cash requirements for growth in inventories.
6. Not factual when valuing small companies.
7. Not effective for companies with few assets, small amounts of debt, or low depreciation or amortization schedules.
 

The EBITDA number for an existing business is important, for the most part, when the existing ownership is establishing their business value for the purpose of a line of credit, borrowing, creating a Trust, stock values, etc., but EBITDA does not have the same importance when selling the business. This is due to the fact the buyer will not have the same expenses as the seller.

 

Buyers may not have the same tax base, interest expense, or the same depreciation schedule, thus it is important that the buyer calculate an estimated EBITDA that is specific to their operating model, business systems, buying power, cost of operations, etc., not the sellers. It should also be noted that EBITDA assumes that the buyer will acquire all of the assets, working capital, accounts receivable, and liabilities. Those assumptions do not always hold true regarding an acquisition of some businesses where the seller keeps the current A/R, is responsible for paying off liabilities, etc. Instead of the EBITDA number, buyers pursuing small business acquisitions should be focusing on sales, gross profit, cash flow, customer mix, etc. 

 

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