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If you are going to sell or buy a business you will eventually come across the term “EBITDA”. No, EBITDA is not an expletive, nor is it a word scramble. Although, I was able to reconfigure the letters into the word BAITED. As in, “you might find yourself baited into a bad transaction if you don’t know how EBITDA works”. EBITDA is, in fact, an acronym that stands for Earnings Before Interest, Taxes, Depreciation and Amortization.
History of EBITDA
EBITDA is a non-GAAP measure used by most investment bankers and M&A advisors as a measure of profits. Because it is non-GAAP it is not required to be reported, and when it is reported items that are included in EBITDA can vary from period to period. EBITDA was used as a key financial metric in the 1980’s when leveraged buyout bankers promoted it as a tool to determine whether a company could cover the heavier interest payments it would face after restructuring. For instance, if a company had an EBITDA of $4 million and an interest payment of $2 million, then that company was said to have 2x (times) interest coverage. The company was considered in good shape to pay upcoming interest expenses on the debt that was used to buy the company.
Since the 80’s, the use of EBITDA has spread because proponents believe that it most clearly presents the profitability of an operation by removing expenses that are not material to operations. However, you should BEWARE and not limit your view of a company’s profitability to EBITDA. Here’s why. EBITDA became popular because it shows more profit than the operating profit line on the income statement. This benefits a seller but doesn’t help a buyer if they use EBITDA as a singular measure of profitability.
Primary Issues with EBITDA
Because EBITDA is not a comprehensive measure of cash flow it ignores working capital, the cash needed to cover day to day operations and it ignores capital expenditures. During growth periods companies invest cash in accounts receivable and inventory to support growth. These investments in working capital and fluctuations from period to period are ignored by EBITDA. The fluctuations in cash caused by the investment in working capital are accounted for in cash flow from operations on the statement of cash flows. Because EBITDA Is not comprehensive it is possible to have a situation where EBITDA is positive, but investments in accounts receivable and inventory (both are working capital components) leave the company with negative cash flow from operations. Positive EBITDA and negative cash flow from operations? That doesn’t sound like a winner.
Furthermore, EBITDA does not account for investment in capital equipment which can be significant for some companies. In addition to the initial capital expenditure (CAPEX), a company will generally need to spend annually to service, upgrade or expand the equipment that was purchased. Although CAPEX can be significant it does not show up in EBITDA.
A capital-intensive company will buy and support fixed assets so considering the cash effect of capital investments is critical.
Because the market has adopted EBITDA for buy / sell transactions you will need to be prepared to at least understand it and possibly use it as well. If you are a seller be aware how the reliance on EBITDA alone may be understating your value so you can account for the increased value right at the beginning of the sales process. If you are a buyer, then beware of the EBITDA trap, by solely relying on that metric, and do the work to understand the total value of the business to you.
By The Gurus of Growth
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