What is EBITDA and Why Should You Care?

If you’re considering selling your company, you’re likely aware that EBITDA is a common valuation metric. But, what is EBITDA? And why should you care?

What is EBITDA?

Let’s start with a definition: EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Another way to think about it is your company’s revenue, minus cost of goods sold, and minus operating expenses (excluding any interest, taxes, depreciation, and amortization).

Before you fall asleep, let’s pivot to why this is useful: EBITDA is used as a proxy for the level of cash generated by a company’s operations (without noise from non-operational factors).

Unlike other cash flow metrics, EBITDA is relatively simple to calculate. It requires only the five inputs and can typically be calculated quickly from the face of a company’s income statement. When considering the level of cash that a company generates from operations, it’s useful to remove non-operational impacts on cash flow. Therefore, EBITDA gives investors a metric to easily compare your company with others.

Why is it useful?

EBITDA is useful in considering the value of a company because it:

  • Normalizes capital structure. EBITDA removes the impact of a company’s capital structure by adding back interest expense. The premise is that financing decisions shouldn’t affect the value of an enterprise because those financing decisions can be easily changed. When valuing a company, most buyers will assume that a company’s debt can be eliminated or refinanced as part of the transaction. Since a buyer can easily change the capital structure of the company, capital structure is ignored in determining value.
  • Normalizes tax structure. EBITDA removes the impact of income taxes. The idea is that this makes firms easier to compare since two companies may have differing tax rates due to legal structure (e.g. C corporation tax payer vs. S corporation or limited liability company tax payer) or geography.
  • Normalizes non-cash accounting decisions. EBITDA removes the impact of depreciation and amortization. These expenses are non-cash accounting constructs. The levels of a company’s depreciation and amortization are influenced by assumptions such as useful life and the value of intangible assets. These assumptions are not standard across all companies and are not indicative of a company’s ability to generate cash.
  • Normalizes short-term fluctuations in working capital. EBITDA removes period-to-period fluctuations in net working capital. Unlike GAAP (generally accepted accounting principles), cash flow from operations from a company’s cash flow statement (which requires a reconciliation of period-to-period changes in balance sheet accounts like accounts receivable, inventory, accounts payable and accrued expenses), EBITDA theoretically illustrates the amount of cash flow a company generates from its operations on a sustainable, run-rate basis without potential noise from factors such as the timing of collecting accounts receivable or a build-up or reduction in inventory.

What are EBITDA Addbacks?

To get to this metric for purposes of a company sale, sometimes owners will need to “add back” into EBITDA certain expenses from the income statement that are actually non-recurring or non-operational items. Aptly termed “addbacks”, these normalize the company’s EBITDA to give buyers a more normalized and realistic picture of what level of EBITDA they’re actually acquiring. Examples of EBITDA addbacks include:

  • Personal or non-business expenses. These are expenses that have historically been run through the company and will not be post-closing. These can include, for example, personal vehicle leases and fuel, personal travel expenses, or personal meals and entertainment.
  • Excess owner compensation. For example, an owner paying themselves a $1 million salary when the market salary for a replacement CEO is determined to be $250 thousand shouldn’t negatively affect EBITDA. This item can also go the opposite way – for owners that choose to take a minimal or no salary, a market salary will need to be burdened to reflect the cost of a replacement CEO. In either case, the goal of this EBITDA addback (or expense addition) is to give a picture of what the position will actually cost the company going forward.
  • Non-recurring expenses. These expenses could reflect a number of different items, including one-time legal fees related to M&A transactions, one-time facility move costs, one-time consulting fees (such as hiring a recruiter to fill a specific position), or costs related to temporary supply chain issues. As these are not expected to recur in the future, they are typically not considered by buyers as expenses to EBITDA when evaluating the company.
  • Certain accounting adjustments. Expenses that should have been capitalized, for example large equipment purchases, are typically adjusted out of EBITDA and onto the balance sheet. Any gains or losses on the sale of assets would also be excluded from EBITDA.
  • Rent. Some business owners own the facility from which their company operates and do not charge rent to the business. The opposite of an addback, rent needs to be expensed as part of the income statement (again, as this is a cost that would be incurred by the company going forward after a sale).

Limitations to EBITDA

Even with all of these advantages, it is important to remember that there are limitations to the utility of EBITDA. For example, EBITDA ignores the amount a company must spend on capital expenditures (e.g. purchases of tangible assets that are capitalized to the balance sheet rather than expensed). Capital expenditures are a necessary consideration and will influence the value of a company. Two companies that each generate $4 million of EBITDA annually will be valued differently if one company has high capital intensity and spends $2 million per year on new equipment to sustain its business while the other requires only $200 thousand of capital expenditures per year to sustain its business. Therefore, while EBITDA is useful, it’s one data point among many that can indicate fair market value.

As you consider a sale of your company, it’s crucial to know what level of EBITDA your company has generated historically and what level of EBITDA your company is likely to continue generating in the future (what we call “sustainable” EBITDA). This will position you to have an informed and transparent conversation with a buyer as to how each party views fair market value. Having prepared your own calculations ahead of time may, at the very least, save you significant time in determining whether you and the potential buyer are likely to reach agreement.