What Is EBITDA and Why Is It Important?

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

Let’s start with a definition: EBITDA stands for earnings before 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 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.

The following are four reasons why EBITDA is useful in considering the value of a company:

  1.  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.
  1.  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.
  1.  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.
  1.  Normalizes short-term fluctuations in working capital. EBITDA removes period-to-period fluctuations in net working capital. Unlike GAAP¹ 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.

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. This will position you to have an informed and transparent conversation with the 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.

¹ Generally accepted accounting principles.

About Montage Partners

Founded in 2004 and located in Scottsdale, Arizona, Montage Partners is a private equity firm that invests in established companies in the western U.S. with EBITDA between $1 million and $5 million. Above all other investment criteria, Montage Partners invests in exceptional people. Montage Partners provides liquidity to those who have spent years of their life building great companies, Montage Partners protects those companies through a transition of ownership and Montage Partners supports the next generation of a company’s leadership in executing on growth initiatives. For more information, please visit www.montagepartners.com.