How to understand true EBITDA

By Reg Burgess

EBITDA matters when you need to know your company’s value

Asking, “What is my business worth?” is a reasonable question. For small business owners, their business is one of their largest assets. At any given time, however, many do not know what that asset is worth.

Earnings before interest, taxes, depreciation, and amortization, or EBITDA, is one standard measure. EBITDA is used in a business sale, to purchase another business, or for cash flow availability with creditors.

Defining EBITDA

Let’s start by defining each of the key components of EBITDA;

• Earnings refer to the Net Profit of the business. It is what is left over after all expenses are included. It is the bottom line.
• Interest is the interest paid on the debt the business carries. This is not to be confused with the entire debt payment, which also includes principal. Only the interest is presented as an expense on the income statement.
• Taxes are amounts paid by the entity and come in various forms. This is highly dependent on the business’s legal structure. Is your business a C-corp, S-corp, LLC, or Sole Proprietorship? Each of these affects how taxes are handled on the income statement.
• Depreciation is a GAAP-defined method for reflecting the reduction of the useful life of a capital asset. Most businesses have capital assets, including production equipment, computers, and other IT infrastructure, as well as leasehold improvements to facilities. A portion of the value of these assets is shown as an expense on the income statement.  Depreciation is a non-cash expense. 
• Amortization, like depreciation, is used to capture the reduction in value of intangible assets, such as patents, copyrights, customer lists, goodwill, and capitalized software. An example of goodwill is when a business has purchased another business. The value in excess of book value at the time of purchase may be carried on the purchaser’s balance sheet as goodwill, an intangible asset. Like depreciation, amortization is a non-cash expense. Again, amortization reduces profitability but does not affect cash flow.

Simple income statement example for a small business

Revenue: $5,000,000

Cost of Goods Sold: $3,000,000

Gross Profit: $2,000,000

Operating Expenses: $1,200,000

Depreciation: $150,000

Amortization: $50,000

Operating Income: $600,000

Interest Expense: $100,000

Taxes: $125,000

Net Profit: $375,000

Calculating EBITDA

Start with Net Profit:

$375,000

Add back:

Interest: + $100,000
Taxes: + $125,000
Depreciation: + $150,000
Amortization: + $50,000

EBITDA = $800,000

Following the example, the company’s EBITDA is $800,000. This should only be viewed as a first pass, as there are other factors to consider that provide a “true” or adjusted EBITDA.  

True EBITDA vs. EBITDA

True or adjusted EBITDA is a way to reflect the business’s actual earnings over time on an equal basis. Have you ever had one-time expenses or revenues that are not part of your business’s day-to-day operations? As an owner, do you have any benefits that the company treats as expenses? True EBITDA addresses these occurrences and others like them.  

One method of business valuation, for example, is based on the EBITDA multiple, in which each dollar of EBITDA is multiplied by a fixed multiple. In this case, the buyer must project the business’s post-transaction cash flow.

For now, we will assume a 4X multiplier in the above example. An unadjusted EBITDA valuation for our sample company is $3,200,000 using a 4X multiple. Without accounting for “normal” adjustments, the owner could be undervaluing the company. This highlights the importance of true or adjusted EBITDA.

Solid accounting methods, along with internal control procedures, create a defensible value of the business that can be tracked over time. 

When is true EBITDA necessary? 

An adjusted EBITDA is used in the sale and/or purchase of a business, succession planning, tax planning, divorce and estate planning, and more. It is also a criterion that banks and other creditors may use to determine creditworthiness. 

Factoring true EBITDA

There are a number of benefits to determining a company’s true EBITDA while addressing open questions that are factored into the adjustments. Primarily, these adjustments are associated with expenses recorded either in Cost of Goods Sold or in Operating Expense.

• Expense-related adjustments: What is the value of all owner compensation and benefits? Note that often these benefits have developed over the life of the business, and owners lose sight of the full extent of these benefits. Expense-related adjustments include:
  • Full owner compensation if it can be demonstrated that the management has the ability and runs the business without owner involvement.
  • Business trips that include personal travel, cell phones, subscription services, fuel cards, credit cards (that blur business & personal expense), family members not active in the business income, non-business-related meals, and entertainment. 
  • Another significant adjustment is for vehicles and related expenses, including fuel, insurance, maintenance, registrations, interest expense, property taxes, etc.

• Interest-related adjustments: Interest itself is excluded in EBITDA, but the following should still be considered when determining capital structure.
  • What is the debt structure of the business? 
  • Is it in short- or long-term debt?  
  • What interest rates are on each type? 
  • Can debt be restructured over time to reduce the overall debt load?  
  • Was debt either retired, restructured, or refinanced during the year?
• Non-recurring expenses: Occasionally, one-time revenues and expenses appear on the income statement.
  • What are those items? 
  • Are the items not part of the business’s operations? 
  • Did the company sell old equipment assets? 
  • Did the business receive money from an insurance loss claim? 
  • Did the business lose a court judgment or incur a fine? 
  • Did the business bring in a consultant to help with an ERP or CRM implementation? 
  • Did one of the business’s customers file for bankruptcy? 
  • Were there one-time legal or accounting services related to any of the above?
• Accounting decisions: Accounting decisions that are holistic to the owner’s overall portfolio can influence the individual business’s EBITDA.
  • Does the business have several interdependent entities? 
  • How are goods transferred between entities, at cost or a standard non-market-based price?   
  • What are the capitalization policies (e.g. capitalization thresholds vs what gets expensed, depreciation schedules, and revenue recognition timing)?

Once the adjustments are identified and properly documented, they can be used year after year to compare results more effectively. More importantly, they help to bridge the gap with other peers in the industry to provide an apples-to-apples comparison. 

A true EBITDA with proper documentation, rigorously followed through procedure and practice, is a recognized indicator of the business’s cash flow. Buyers and creditors can more accurately evaluate the Return on Investment for the buyer or the ability to cover additional debt for the creditor.

The limitations of true EBITDA

True EBITDA is not without limitations. Using true EBITDA as a single indicator of a business’s health is not recommended, as it factors out the real costs of running the business. By definition, depreciation is excluded from EBITDA. Ongoing investments in equipment are required to keep a business efficient. 

Warren Buffett is credited with having said, “Does management think the tooth fairy pays for capital expenditures?” 

High or low depreciation levels can signal the need to ask future questions. Since true EBITDA is not a GAAP-standardized metric, it can be subject to “aggressive add-backs” to EBITDA. In addition, high taxes and interest rates affect cash flow, providing a false sense of the business’s current state. 

If the business can handle the interest and tax load, it may stop an owner from looking to optimize both. Does the owner have a strategic tax plan? Can high-interest debt be restructured to a lower interest rate and longer term? Most importantly, does the business have free cash to invest in growth, or is it tied up in excessive working capital?

The role of succession planning in true EBITDA

What is the business’s succession plan? Succession planning plays a significant role in a true EBITDA. For adjusted EBITDA to be used as a measure of future cash flow for a buyer, the owner’s compensation may be offset by a general manager’s salary if the owner is integral to the operation.

Without a clear demonstrated succession plan, buyers will discount (reduce the multiple), disallow add-backs, or create holdbacks to transaction value, all of which will negatively impact the company’s valuation.

The benefits of developing a true EBITDA

True EBITDA helps the owner identify legitimate “add-backs” that can significantly boost enterprise value. Using true EBITDA to track performance 3-5 years before a sale allows owners to identify and fix operational inefficiencies. This sets each business year on the same basis.

Well-documented adjustments build buyer and creditor trust by reducing risk, thereby reducing friction during the due diligence process. True EBITDA also helps owners make better internal investment decisions by focusing on which segments/sub-businesses drive the most operational profit.

What are the next steps to develop a true EBITDA value? 

1. Work with specialized advisors to ensure adjustments are defensible. Often, what an owner wants to consider a non-standard expense or level of owner compensation to add add-backs that are not considered “normal.” Experienced advisors who routinely work with buyers and creditors can help establish best practices.
2. Make sure your financial house is in order, and all accounting practices are buttoned up. For instance, clearly define revenue recognition, general ledger structures, standard accounting practices, and internal control mechanisms.
3. Work to understand your main financial documents: the income statement, balance sheet, and statement of cash flows. True EBITDA provides value, but it cannot be viewed in a vacuum.  Changes in the balance sheet and the statement of cash flows are important, too.
4. Determine capital expenditure needs for the current state of the business and to support growth.
5. Ask yourself: Is a portion of your cash flow devoted to growth and development? Do you have a budget to identify and support these investments? What are the working capital needs of the business? Has it changed over time, and why? What will it need to be based on growth expectations?

True EBITDA is a useful measure to help a business owner better understand what, for many, is their largest single financial asset. Developing this measure will help a business improve operations and position itself for growth.