Calculating EBITDA: How Profitable is Your Business?
The profitability of your company can be evaluated in several ways, but most investors start with calculating Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). The investment banking team at Doeren Mayhew Capital Advisors shares insight into understanding EBITDA, key ratios used by investors and lenders, and ways to adjust your calculation before entering the merger and acquisition (M&A) market.
What is EBITDA?
EBITDA is widely used to measure the profitability of a company, especially throughout the M&A process and by lenders. Investors want to know the historical profitability of your business, and EBIDTA helps them assess how much money your company is making before interest, taxes, depreciation and amortization is applied. It can also be used to analyze and compare profitability between similar companies and within your industry, because it eliminates the effects of financing and accounting decisions. EBITDA is calculated by using the following formula:
EBITDA = Operating Income + Interest + Taxes + Depreciation + Amortization
Consider this example:
TTM EBITDA is used to trend how a business is performing without the effects of seasonality and on an annual basis.
How EBITDA Is Used
While EBITDA offers insight into the profitability of a company, it alone is never the sole factor in an investment decision. The most common ratios used with EBITDA include:
- EBITDA/Interest Coverage: This ratio is used by lenders to assess a company’s financial stability by examining whether it’s at least profitable enough to cover its interest expense. A business above a 1.5 ratio ensures the company can easily pay off its interest expenses. If a ratio dips below one, it is likely that the business can’t afford its interest, leaving a lender or investor with uncertainty.
- Debt/EBITDA: When a lender reviews a business’ debt/EBITDA ratio, they are evaluating a company’s ability to pay off incurred debt and the amount of time it would take. A high ratio reveals a company’s inability to pay its debt in a timely manner. Often, lenders and investors want to make sure a business’s debt/EBIDTA doesn’t exceed three times, but this depends on the type of debt. Long-term assets and related debt are often excluded from this ratio. Investors care about this ratio because it illustrates how much leverage the business can add or have outside of equity investment.
- Total Enterprise Value (TEV)/EBITDA: Investors commonly use this ratio because it helps them determine initial business value and a sales price on a debt-free basis, so they can then apply their own decisions on how to structure an acquisition and calculate return on their potential investment.
For example, a buyer may identify five publicly traded companies that are very similar to your business model and use those industry multiples to evaluate your TEV. If your industry multiple is six, then your business is worth six times its EBITDA. Investors also look at size premiums on these multiples of EBITDA to plan for an eventual exit.
Adjustments to EBITDA
Financial statements of small and mid-sized businesses often misrepresent a company’s profitability because of various owner expenses used to reduce income and minimize taxes. Before entering the M&A market, consider working with an investment banking advisor like those at Doeren Mayhew Capital Advisors to help “normalize” or adjust your EBITDA calculation. Typical EBITDA adjustments include:
- Owner salaries and employee bonuses. Family-owned businesses often pay owners and family members’ higher salaries or bonuses than other company executives or compensate them for ownership using these perks. A buyer would no longer need to compensate the owner or executives as generously, so consider adjusting salaries to current market rates based on their role in the business.
An owner’s salary may also serve as a benchmark for post-sale earnings. For example, if your business is worth six times its EBITDA, then you may want to be conservative with your owner salary if you anticipate only staying with the company for one to two years post-transaction.
- Any other owner’s personal expenses. Perks enjoyed by business owners such as company cars, club memberships, entertainment and more are eliminated if it not likely to be continued after the transaction. Owner expenses likely to continue should be adjusted to market based on the role in the business.
- One-time expenses. Consider your one-time, non-recurring expenses not usually part of your company’s day-to-day operations that could be added back to EBITDA. These may include legal fees for an unusual event, repair costs from a natural disaster, changes in policies that have a financial impact, or write-offs of bad debt that aren’t normally in the course of your business.
The example below illustrates the impact of earnings adjustments to an EBITDA calculation:
As the example demonstrates, normalizing your financial statements eliminates discretionary, nonrecurring and unusual items, and helps increase your business value.
For more information on calculating EBIDTA and how to prepare your business for sale before entering the M&A market, contact our M&A advisors today.