What is EBITDA?
EBITDA is an accounting term used primarily to help you understand the performance of your business.
It is an acronym for Earnings before Interest, Taxes, Depreciation, and Amortization.
EBITDA includes the profit your business made and all interest, taxes, depreciation expense, and amortization expense for the year.
Why is EBITDA so important to understand?
For Sellers: EBITDA is often used to calculate the value of your business. Here’s a basic version of this formula:
For Buyers: EBITDA is a one way to determine the historical profit of a business. Keep in mind, this isn't the only method - and it's not fool proof. Some decisions made by the current ownership may not apply to you and capital expenditures are not factored in.
How is EBITDA calculated?
We’ll start with an income statement.
The formula we’re going to use is:
Net Income + Interest Expense + Depreciation Expense + Amortization Expense + Taxes
Below are explanations of each part of the equation:
If your business is a C corporation, you will have taxes to add back. If your business is an LLC, S corporation, partnership, or sole proprietorship, you paid your federal and state income taxes personally and should not add them to the net income.
Payroll taxes, sales tax, and other non-income taxes are also not added back.
Now, let’s run through an example.
Example EBITDA Calculation for Small Business
Most small businesses file their taxes as a pass-through entity or on the owner’s personal tax return. This S corporation return might look different than yours, but the calculation is the same.
This business had $1,047,983 in net profit but $1,219,101 in EBITDA. This could translate into hundreds of thousands of dollars in value to a potential buyer.
You’ll notice the tax return shows $48,784 in taxes (line 12) but we didn’t add taxes back. Why?
The “Taxes and Licenses” account for this S corporation includes payroll taxes, local government taxes, and other permits required to run the business.
Since this is an S corporation, it did not pay corporate income tax. Depending on your industry and if you acquired your business, you might not have amortization expense either.
Interest expense of $3,181 was completely added back because a new owner will have their own capital structure. Removing interest allows for an apples-to-apples comparison between companies.
Depreciation and amortization expenses are also completely added back. These non-cash expenses do not directly affect the cash an owner receives.
Is EBITDA the right metric for your business?
The size of your company and which buyers are interested will determine which metric to use.
Different types of buyers will prefer to use different earnings calculations.
If your company has earnings under $1 million:
The most common way to value a small business with earnings under $1 million is by using seller’s discretionary earnings (SDE).
Chances are, your business will most likely be acquired by an individual buyer - someone looking to directly operate the business. Therefore, its necessary to determine the amount of money the business would provide to one full-time owner-operator.
Calculating SDE is similar to EBITDA but can be a bit more involved.
For a complete understanding of how to calculate your SDE, use our guide here.
Individual buyers often use the SBA 7(a) loan program to acquire a company worth less than $5 million. SBA requires the use of SDE.
This chart shows how our example company’s EBITDA, SDE, and Net Income compare.
If your company has earnings over $1.5 million:
If your business has earnings over $1.5 million, you should use EBITDA in your business valuation.
Private equity groups and strategic buyers are more likely to be interested in your business and will use EBITDA.
Whether to use EBITDA or SDE heavily depends on which buyer is looking at acquiring your business and how involved you are in the day-to-day operations of the company.
If your business is between $1 million and $1.5 million in earnings both methods can be used to understand what different buyers will see.
How is EBITDA different than Cash Flow?
EBITDA and SDE remove your business’s equipment purchases, interest payments, and taxes. But these are all real expenses that affect what you put in your pocket.
Understanding the true performance of your business involves looking at all real expenses. Cash flow is a better metric for you to understand what you put in your pocket every year.
Investors will use EBITDA because it is easier to compare across companies, even if it often paints a less than accurate picture of your business’s profit.
See the examples below for the difference in the two metrics.
What is EBITDA Margin?
EBITDA margin is another measure of your business's performance.
To find it, take your EBITDA and divide it by total revenue.
This is a popular measure of financial performance for private equity groups.
Selling your business is a journey. One of the first steps is to understand your business value.
Whether you're ready to sell or in the planning stage, knowing your EBITDA and how to calculate is an essential skill.
If you have questions about calculating your EBITDA, or determining if it’s the right measure for your business, feel free reach out to me at email@example.com