Can EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization) Impact Small Businesses?
How valuable is your small business? Whether you are trying to determine your ability to repay debts, applying for a small business line of credit, performing a financial analysis is crucial. If you are familiar with the accounting lingo, you may have heard the acronym EBITDA. If not, we will explain.
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What is EBITDA?
Earnings before Interest, Tax, Depreciation, and Amortization (known as EBITDA) is an important financial measure that has become extremely popular and widely accepted and utilized in financial markets for various purposes, such as financial statement analysis, business valuation and credit analysis, among others. It is a common tool that is used by both financial analysts and investors.
EBITDA is a financial measure that can provide you with an idea of your small business' value and efficiency. It acts as a viable alternative to other performance metrics, such as revenue, net income, or earnings. Your small business’s EBITDA is one of the key indicators of the overall financial health of your business.
It is worth mentioning that having a good EBITDA margin signals to lenders, investors, and customers that you have impressive baseline profitability and can also afford to repay your business’s debts.
Bankers also like EBITDA as it eventually represents operating cash flow (as the non-cash expenses, like deprecation, are added back in). This helps explain why bankers prefer the ratio in most loan covenants. If your EBITDA is good, your operating cash flow won’t be far behind.
Here is what all the different terms in EBITDA mean.
It is the profit that you can find at the bottom of your small business' income statement. Note that this term is often interchangeable with the net profit or net income.
This represents any interest payment that you make on your current small business loan or line of credit. Note that the amount of interest usually varies depending on the amount of money your business has borrowed.
This is the amount that you have to pay in income taxes, sales taxes, and payroll taxes. Note that small business taxes are regulated by federal, state, and local governments.
Depreciation and Amortization
The depreciation amount and amortization amount are found on the profit and loss statement and cash flow statement. Depreciation takes into consideration the diminishing value of your business’ tangible assets. Amortization, in contrast, is for “intangible assets” such as patents and copyrights.
You can calculate EBITDA for your small business using the following formula:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
You will have all the pertinent information you need for calculating EBITDA on your profit and loss statement.
How EBITDA Impacts Small Businesses
EBITDA is a meaningful measure of your small business’ operating performance since it allows you to more fully evaluate the productivity, return on capital, and efficiency of your business without factoring in the impact of variables, like interest rates, taxes, and other operating expenses.
Importance of EBITDA
How to calculate EBITDA and apply it is crucial for business owners for 2 key reasons:
1. It helps you get a clearer idea of your business’ value.
2. It demonstrates to buyers and investors the worth of your small business.
EBITDA helps you, as an owner, to analyze and compare the profitability of your business with other businesses in the same industry. And as the figure eliminates the effects of government, financing, or accounting decisions, it provides you with a rawer and clearer indication of your business earnings.
EBITDA indicates the total cash inflow your business has received for an accounting period. Hence, a higher EBITDA often means that your small business has more cash available in order to cover its expenses.
EBITDA’s importance is evident as it is now the standout formula applied by many professional buyers, lenders, and private equity investors when discussing and comparing business value.
Uses of EBITDA
EBITDA is used for various analytical purposes, which indicates the different ways it can impact small businesses. However, the main rationale behind its application in most instances stems from the notion that this number provides owners a clear measure of the raw operating earnings of their business, excluding financing costs, asset diminution charges, and tax expense.
EBITDA provides you with a benchmark against which you can assess the quality of your business’ reported earnings by undertaking a reconciliation to gross operating cash flow
EBITDA can also provide you with a starting point in the calculation of your corporate cash flow
EBITDA gives an indication of the possible debt burden that your small business can endure, through liquidity measures, like EBITDA/Interest or Debt/EBITDA
EBITDA also provides an important input in different valuation analysis, particularly DCF valuation and EV/EBITDA valuation.
Also, it’s usually used as a proxy for cash flow to help provide you with an estimated valuation range for your small business by using the famous EBITDA multiple.
What is Considered a Good EBITDA?
How can you determine if your business has a good EBITDA or not? You can find out by calculating your business’ EBITDA margin with this formula.
EBITDA Margin = EBITDA / Total Revenue
Note that EBITDA margin indicates what percentage EBITDA is of your total revenue. Keep in mind that what is a “good” EBITDA margin will mainly depend on your industry. However, generally, a higher EBITDA is better compared to a lower one.
A higher EBITDA margin shows that your business has sufficient revenue left over after paying for your operating expenses. EBITDA allows you to look at your business earnings before factors such as taxes, interest, and depreciation. This number can help you determine which factors have the most significant impact on your net income.
The EBITDA margin is important as it shows you how efficient your operating cash flow is. Company X, for example, has an EBITDA of $50,000 with revenues of $200,000. In contrast, Company Y has an EBITDA $60,000 with revenues of $300,000. In this case, the EBITDA margin is 25 percent for Company X and 20 percent for Company Y.
Many people would think that company Y is performing better as it has higher EBITDA as well as revenue. However, Company X is more attractive as it utilizes its cash flow more efficiently because of its higher EBITDA margin.
Pros of EBITDA
EBITDA nullifies or cancels the effect of some accounting decisions, like the use of different amortization and depreciation methods.
EBITDA acts as a building block for some key ratios, including the popular enterprise multiple, margin formula, and coverage ratio. As EBITDA serves as an important part of these ratios, it makes it simpler for valuation purposes.
EBITDA provides a more accurate view of your business’ operational performance as it disregards expenses, like interest and taxes, which aren’t the actual results of operations.
EBITDA makes it easier to calculate your company’s ability to pay long term debts. You can accomplish this by using the debt coverage ratio. Divide your EBITDA by the number of debt payments.
EBITDA and Small Business Valuation
There are a number of ways to value your business. One of them is the EBITDA valuation method, and it relies on a multiple of EBITDA in order to arrive at your company’s enterprise value. EBITDA is one of the most common ways to value your small business.
As the earnings from your business are likely based on your personal income taxes, you should value your small business in a way that removes your personal tax inputs. Note that this is particularly true if your business is a sole proprietorship.
In many cases, small business owners obsess about the earning multiple their company would fetch when sold. Although there is no denying that the multiple is important and relevant – a business that’s sold at nine times EBITDA is worth 50% more than if sold at six times multiple – this focus can often be misguided.
This is because the multiple of EBITDA at which a small business is sold is, very frankly, out of the direct control of business owners.
As a small business owner, you have to understand that the market usually determines the earnings multiple through the sale process that is orchestrated by the seller’s financial advisor or investment bank that ideally involves multiple potential buyers. However, EBITDA is under your control. By enhancing your business’ EBITDA, you can maximize the gain you will derive.
EBITDA provides business owners and users of financial statements with insights regarding how well a business is performing compared to other companies and estimating its worth. Being aware of this important financial metric will help you better understand the baseline profitability of your business and the kinds of debt your business can handle—and whether or not you will be successful in taking on more.
Understanding what EBITDA is and the various factors that affect it will help you plan ahead and considerably improve your bottom line in the future.