When I was growing up in the south suburbs of Chicago, a highlight was going to our local high school basketball games. I’m dating myself, but the pep band would play a peppy Chicago tune or the Hawaii-5-0 theme – a good old time. The cheerleaders would also do the cheer – gimme a V, gimme an I, etc until we were screaming GO VIKINGS!
Similarly, if you are interested in selling your business, the Mergers & Acquisition (M&A) community will be looking at you and shouting – gimme an E, gimme a B, etc until they are cheering you on with GO EBITDA! It is an important concept and one you will hear regularly.
So what is EBITDA? The easy answer is Earnings Before Interest Taxes Depreciation and Amortization (E+I+T+D+A) but let’s look at each component in a little more detail.
- Earnings – typically this equates to net income on the income statement although I’ve also seen operating income as the starting point.
- Interest – this relates to interest expense or the charges you receive in relation to incurring debt in order to run your business.
- Taxes – this is income taxes. For a C Corp, this is typically a line item on the income statement. This does not typically apply for an S Corp or an LLC.
- Depreciation – this is depreciation on fixed assets which is a non-cash expenditure.
- Amortization – this is amortization on certain intangible assets which is also a non-cash expenditure.
Now that we know what EBITDA is, how is it used?
The M&A community uses EBITDA as an indicator of profitability for a company. By taking interest, taxes, depreciation and amortization out of the equation, it provides an indication of what the true operating profit of the business is absent of non-cash expenditures, discretionary financing (interest) and regulatory charges that may vary by jurisdiction (taxes). By taking EBITDA margin into effect (EBITDA/revenue), the higher the margin, the more profitable a company may be in comparison to another like company.
One needs to be careful in solely using EBITDA or EBITDA margin as an indicator. What is positive EBITDA? Although a positive EBITDA or EBITDA margin is good, it isn’t an indicator on its own that the business is generating enough cash flow to fund its fixed assets, bank financing requirements or owner distributions, amongst others. Also, some people feel that EBITDA is a measure of cash flow, it is an element of cash flow being profitability but should not be used solely to judge the adequacy of a company’s cash flow.
Using EBITDA in conjunction with other measures is typically an appropriate way to track metrics related to the health of your business. These measures will vary by industry and the goals set by respective ownership groups. Learning how these metrics are defined and measured will help you understand the drivers for controlling them.
After discussing, what it EBITDA, hopefully now you have a better understanding of what EBITDA is and its impact on your business.