6 minute read

Cash Flow vs. EBITDA: Which Valuation Metric Should You Use When Buying or Selling a Business?

Cash flow and EBITDA valuation metrics displayed on computer screen.

When it comes to valuing a business for sale, choosing the right financial metric makes all the difference. Two common approaches stand out: cash flow (also known as seller’s discretionary earnings, SDE) and earnings before interest, taxes, depreciation, and amortization (EBITDA). Understanding which method fits your situation can help you arrive at a fair business value.

Cash flow/SDE looks at the actual money a business generates and works for smaller, owner-operated companies. EBITDA provides a standardized view of operational performance by removing financial complexities, making it ideal for larger or more complex businesses.

We'll explore their definitions, calculation methods, industry applications, and key differences, so you can choose the most appropriate valuation metric for your business.

When Cash Flow/SDE Makes Sense

Cash flow or SDE analysis and works best when the business owner plays a central role in daily operations and when personal and business finances intertwine. This method particularly suits:

Owner-operator businesses where the owner handles day-to-day operations. These companies often blend personal and business expenses, so cash flow/SDE valuation adjusts for owner-specific costs to show true earning potential and including working capital.
Single-location businesses that depend heavily on the owner’s involvement. Cash flow valuation helps potential buyers understand the actual economic value beyond standard financial statements.
Service-based businesses with financial nuances that traditional metrics might miss. Cash flow provides a complete picture by including owner benefits and discretionary expenses.
Family-owned operations often have complex compensation structures and family member benefits that might not be reflected in standard financial reporting. Cash flow valuation provides a clearer picture of the business's true earning potential.

When EBITDA Works Better

Earnings before interest, taxes, depreciation, and amortization (EBITDA) proves most valuable for larger or more complex businesses that need a standardized way to assess financial performance. This method works well for:

Businesses with professional management teams. EBITDA gives a clearer view of operating profitability by removing the impact of financial and accounting decisions, showing core earnings potential and operating activities without owner-specific adjustments.
Multi-location operations benefit from EBITDA’s ability to normalize financial performance across different business sites by excluding capital expenditures and non-operating expenses to provide a consistent measure of operational efficiency.
Larger revenue businesses use EBITDA which helps investors and potential buyers understand the company's operating cash flow without being affected by ownership or varied accounting practices.
Investment-owned and franchise businesses can use EBITDA to compare earnings across different entities, making it valuable for potential investors.

Calculating Your Business Value

For cash flow/SDE, start with net income and add back owner-related and one-time line items, such as:

Owner’s total compensation
Personal expenses charged to the business
One-time outflows like legal fees or major purchases

This adjustment process accounts for irregular financial activities and seasonal variations while removing non-operating income.

For EBITDA, begin with net income and add back:

Interest expenses
Income taxes
Depreciation and amortization

This method strips away financial details to focus purely on operating performance, making it ideal for comparing businesses with different capital structures.

How Business Structure Affects Your Choice

The decision to use cash flow or EBITDA depends on how the company is organized.

Management team considerations: Businesses with professional management teams typically benefit from EBITDA. It provides a standardized view of operational performance separate from ownership.
Owner involvement: Cash flow is better for businesses that heavily rely on the owner because it shows their financial role in the business.
Scalability factors: Growing businesses may need metrics like EBITDA to standardize financial performance at different stages.
Transfer of responsibilities: EBITDA offers a more objective financial snapshot that can make ownership transfers smoother.
Infrastructure requirements: Businesses with significant technological systems or operational processes can choose which valuation approach most accurately captures the business's true financial potential.

Industry-Specific Considerations

Different industries require nuanced approaches to financial valuation.

Service businesses typically align better with cash flow since their value often depends on the owner’s expertise and personal relationships.
Retail operations benefit from EBITDA's comprehensive view of financial performance.
Manufacturing sectors require complex financial analysis due to significant capital investments. EBITDA is an important metric because it focuses on operational efficiency by removing non-cash items and accounting for substantial infrastructure costs.
Professional practices like law firms or medical groups similarly find EBITDA valuable for comparing performance across different operational models.
Franchises have unique challenges, so EBITDA provides consistent financial comparisons across multiple locations.
Online businesses often use EBITDA to highlight core profitability and growth potential due to their rapidly changing cost structures and scalability.

BizBuySell has many tools and resources to help you get started on determining the worth of a business—whether your buying, selling, or just looking for a market valuation: