It’s time for your quarterly meeting with your accounting team – your contracted bookkeeper and your accountant. While you are getting settled at the meeting room table, you overhear the two of them talking…
“Hey, Jerry. Did you reconcile the A/P aging to the G/L?”
“No, I haven’t gotten around to it yet because I was looking into our outstanding A/R.”
“OK. Has our inventory turnover improved?”
“Nope, it still sucks!”
“Ah, that’s too bad. Can you believe Cheryl posted that entry to R/E?”
“No way! That’s a newbie mistake…[shaking head]”
“For sure. Hey, don’t forget to add that item we discussed to the M-1 Schedule.”
“No problem, it’s on my list for today.”
As you watch them with deer-in-the-headlight eyes, you feel like you are listening to a foreign language. Sure, you are able to pick up a few words, but have no idea what they are talking about. Sound familiar?
If you’ve ever felt left out of the conversation when your accountant or bookkeeper starts talking (So. Many. Acronyms!), that’s a warning flag that you need to brush up on basic financial knowledge to protect your business and spur growth. My philosophy is that your question is the BEST question, so don’t ever be afraid to ask for clarification if you don’t understand. I’m available to serve as your financial tutor if you need help truly understanding your business’s financial records and outlook.
One acronym in particular that is worth understanding, specifically if you are looking to sell your business in 3-5 years, is EBITDA. And it’s absolutely ok to ask what it is, why it matters, and challenge it in a game of Scrabble. Sorry, fellow nerds, it’s not recognized in the official Scrabble Dictionary.
What Is EBITDA?
EBITDA = Elephants are Big In The Deserts of Africa
When I was a little girl, I would make a game out of guessing what the acronyms meant that adults used. For example, when I overheard my dad discussing his Ph.D., I asked, “Does PhD stand for Pleasant Hill Document?” Pleasant Hill was a nearby city where I lived and the only association I had with those letters. They got a good laugh and corrected me.
So what does EBITDA really stand for?
EBITDA, pronounced, “ee-bit-dah” or “eh-bih-duh,” is your business’ total income before interest, taxes, depreciation, and amortization have been subtracted.
Just like the definition states, EBITDA stands for:
EBITDA is a measurement tool that many business brokers and buyers use to evaluate the profitability and (rough) cash flow of a business. In layman’s terms: It gives you a quick look at how much money is coming into the business. In more specific accounting terms: It helps a potential buyer evaluate operating profit since it removes the cost to run the business (interest & taxes) and large non-cash expenses (depreciation & amortization) to provide a “purer” look at profit.
Dissecting EBITDA: Understanding Real World Application
Let’s take a deeper look at each of the elements of EBITDA.
- Earnings = net income | Start with the grand total of your net income, then add back interest, taxes, depreciation, and amortization. These are all expenses and may vary depending on the business, as you can see below.
- Interest | Interest is considered a cost of doing business. Sometimes cash has to be borrowed to meet immediate needs, so to calculate EBITDA, you’d need to add that expense back to the net income number. A new owner may not have to pay interest if they have enough cash, so removing this provides a clearer view of cash flow from the perspective of a potential buyer.
- Taxes | Income taxes are not included in EBITDA because they will always be only a percentage of your net income, and you can’t really avoid those (unless you don’t want to be profitable!). How much a business pays in taxes can also depend upon the tax structure of the business, and how aggressive the tax advisor is. This may all change under new ownership, so taking it out of the equation paints a clearer picture for a potential buyer.
- Depreciation | Depreciation and Amortization (next on the list) are both non-cash items in the period they are expensed. Depreciation expense is what you record to spread the cost of fixed assets over the time you use them.
- Amortization | Amortization is also used to spread a cost over the time you use something, and is usually for intangible items like patents, trademarks, or goodwill. Both Depreciation and Amortization get added back because the cash was already used when the items were purchased. They are usually the largest cash flow adjustments.
Two Important Notes:
- Not every business will have all 4 elements of EBITDA to add back into net income and that’s OK. If your interest expense number is “0,” then it’s “0” and you move on to the next.
- While EBITDA can make your business look really great in a sale situation, note that it isn’t a recognized principle under GAAP (Generally Accepted Accounting Principles) because it leaves out important expenses.
Thinking Of Selling Your Business?
Many brokers and potential buyers of your business will use your average EBITDA number over each of the last five years (for example) as a starting point for the worth of the business.
If you operate using accrual basis accounting, your number should be relatively consistent (or growing) and not jumping all over the place – which is a good thing! Learn more about cash vs accrual accounting in Is Cash Basis Accounting Driving You Towards A Collision? Accrual Basis Can Save You.
Brokers and buyers then have a “multiple” they use (such as 3x) to multiply your EBITDA number by in order to determine a purchase price for the business. Let’s say your annual net income is $2 million, your EBITDA is $2.5 million, and your business has been consistently growing for the last 5 years. A broker may determine your multiple is 3 (it’s the best kind of business to buy!) then the formula they will use to determine the worth of your business is EBITDA ($2.5 million) x multiple (3) = purchase price ($7.5 million). Congratulations!
The multiple they use can vary widely based on many factors, including your business industry, and how well your company is run (e.g. YOUR daily contribution vs. the business running itself without you).
Prepare Now To Maximize Profit When Selling Your Business
If you are considering selling your business in 3-5 years, call me to learn ways to maximize the sale price you can get for your business. If you prepare ahead of time, I can smooth out any financial wrinkles that may lower your selling price when it comes time to sell. My goal is to financially position you and your business in the best way possible before you sell it, so you can maximize your profit. Contact me today for a free consultation!