6 minute read

What Is EBITDA and Why It Matters in Business Sales

EBITDA is a financial metric that helps both buyers and sellers of small businesses determine valuation, negotiate deals, and understand a company's operational performance. In essence, it measures a business's profitability. When calculated during a business sale, it provides potential buyers and sellers with a clearer view of earnings by excluding capital expenditures and non-operational costs.

What Is EBITDA?

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It's a calculation that helps gauge a company's operational profitability, which is particularly useful when evaluating small businesses for sale. EBITDA focuses on core earnings but excludes non-operating expenses, providing insight into a company's financial performance without the effects of capital structure and tax strategy. The EBITDA margin standardizes earnings, which helps potential buyers compare profitability across different small businesses and industries.

Importance of EBITDA in Business Valuation

While Seller's Discretionary Earnings (SDE) is often preferred for small businesses, EBITDA becomes increasingly important for businesses with substantial earnings, typically those making one or two million dollars or more. These companies often have professional management teams, which makes EBITDA a reliable measure of a company's operations.

For small business owners considering selling their company, understanding EBITDA is vital. It's one of the key metrics displayed on BizBuySell’s business-for-sale listing pages, making it essential for sellers to calculate and present it accurately. For potential buyers browsing these listings, EBITDA provides a standardized way to compare different business opportunities.

By excluding interest, taxes, and non-cash expenses, EBITDA can provide a clear picture of a small business's core profitability, allowing for a more accurate comparison across other businesses in the same industry or of similar size.

EBITDA is widely used in business valuation through various ratios, such as the EV/EBITDA multiple. This ratio compares a company’s enterprise value (EV) to its EBITDA, helping investors assess the relative value of the business. It’s beneficial for evaluating companies with significant asset bases and those in capital-intensive industries, such as manufacturing and utilities. These industries often have substantial depreciation and amortization, making EBITDA a more relevant measure of operational profitability than net income.

How to Calculate EBITDA

For business owners preparing to list their business for sale, here’s how to calculate EBITDA:

1. Start with Net Income: Obtain the company's net income from its financial statement or income statement.
2. Add Back Interest: Include any interest payments to the net income to focus on operating performance.
3. Add Back Taxes: Factor in the income tax expense to eliminate the impact of tax strategy on earnings.
4. Add Back Depreciation and Amortization: Include non-cash expenses related to depreciation and amortization expenses.

Example Calculation:

Suppose a company’s financials are as follows:

• Net Income: $500,000
• Interest Expense: $50,000
• Taxes: $150,000
• Depreciation and Amortization: $100,000

In this example, the company’s adjusted EBITDA is $800,000. This figure reflects the company’s operating profit and total revenue potential before accounting for interest, taxes, and non-cash charges, which is a better indicator of financial performance.

Role of EBITDA in Asset Sales and Business Transactions

When listed on a business-for-sale page, EBITDA is one of several important financial metrics that help potential buyers assess the financial health and earnings potential of a small business. On BizBuySell, business-for-sale listings include a variety of key metrics such as asking price, cash flow (SDE), gross revenue, inventory, EBITDA, rent, FF&E (Furniture, Fixtures, and Equipment), and year established.

It's important to note that while EBITDA is a valuable metric, many small business transactions use Seller's Discretionary Earnings (SDE) for valuation purposes. SDE is particularly relevant for smaller businesses where the owner's compensation and benefits are significant factors in the business's financial picture.

However, EBITDA remains an important metric, especially for larger small businesses or those with more complex financial structures. It provides a standardized way to compare different business opportunities, particularly when looking at businesses across various industries or sizes.

When evaluating a business using both SDE and EBITDA:

• SDE gives insight into the total financial benefit available to a single owner-operator.
• EBITDA provides a view of the company's operational profitability, which can be especially useful for businesses with multiple employees or more complex operations.

Understanding both metrics can give a more comprehensive picture of a business's financial health and potential.

Limitations/Criticisms of EBITDA

While EBITDA is valuable, small business owners and potential buyers should be aware of its limitations:

• Does not represent cash earnings: EBITDA excludes important factors like interest and taxes, which affect a company’s cash flow and liquidity.
• It ignores asset costs: By omitting depreciation and amortization, it may overlook the costs associated with maintaining and replacing assets, which can be significant for small businesses.
• Can have inconsistent starting points: Different companies may use varied figures for the operating income or intangible assets, making comparisons across businesses inconsistent. This variability can affect the reliability of the EBITDA ratio as a measure of financial performance.
• Valuation can be obscured: It’s important to use EBITDA with other generally accepted accounting principles (GAAP) for a comprehensive understanding of a company’s value.

The Role of EBITDA in Business Sales

For small business owners looking to sell, EBITDA is a key metric to highlight. It gives potential buyers a clear snapshot of the business's operational profitability. Since it excludes non-operating expenses, EBITDA shows the core earning potential of the business.

For buyers browsing business-for-sale listings, EBITDA provides a standardized way to compare different opportunities. However, it's important to consider EBITDA alongside other financial metrics and due diligence factors when evaluating a small business purchase.

Remember, while EBITDA is a valuable tool in small business transactions, it should be used in conjunction with other valuation methods to ensure a comprehensive overview of a company's financial health and profitability. Both sellers and buyers should consider seeking professional advice to interpret EBITDA and other financial metrics in the context of a specific business sale.

Visit BizBuySell’s Broker Directory to find a business broker to help navigate selling, buying or valuing a business.

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