What is EBITDA and Why is it Important?
Anyone thinking about selling their business should familiarize themselves with EBITDA.
EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization, is the leading measurement for valuing a business and determining what a buyer might be willing to pay. It’s a way of showing operational cash flow for a business by excluding non-operating factors like interest expense and tax rates. More simply, EBITDA reveals “normal” operational earnings, allowing prospective buyers to accurately evaluate and compare companies through the M&A process.
What to know
Let’s consider two fictional businesses.
Business A and Business B operate essentially the same, with equal revenue and cost of goods sold. The one notable difference is financing: Business A was funded with equity and therefore records no interest expense. Conversely, Business B shows an interest expense because it was funded by debt, effectively dropping net income below that of Business A’s net income.
Although Business A shows higher net income, the businesses have the same EBITDA. Furthermore, because they have equivalent revenue, Business A and Business B have the same EBITDA margin—EBITDA divided by revenue—which is how companies are often compared. If a company’s EBITDA margin is below that of industry peers, suggesting the company is not performing as well as the rest of the market, an owner may have a challenging time selling their business or getting the value they want.
What is adjusted EBITDA?
In most M&A transactions, adjusted EBITDA is used to account for owner-related expenses, as well as non-recurring items such as litigation expenses and asset write-downs. We recommend that owners review and minimize owner-related expenses before a sale so that the financial presentation is cleaner. This leaves fewer items for a buyer to scrutinize. In addition, during a buyer’s due diligence, owners should make sure they have documentation to confirm both the owner-related and one-time expenses are addbacks.
What else do buyers look at?
While EBITDA is the foundation for M&A decisions, there are other factors that buyers use in their analysis that can affect a valuation, such as the prevalence of intellectual property or barriers to entry. Buyers will also analyze revenue to understand if it is recurring and reliable, or project-based. As well, buyers will look at a company’s customers to understand any customer concentration issues, get a feel for the strength of those relationships, and determine whether there are any end-markets issues. Two other issues that are taken into account on valuation are the size of the business and historical revenue growth rates. While this isn’t an exhaustive list, this is a good place to start.
Importance of reliability
A final consideration for sellers is the reliability of financials.
A company should prove they have strong internal controls and robust financial processes with a strong internal team. They should have some type of third-party validation of financials through an audit or review covering the last 3-5 years.
Many businesses will complete a sell-side quality-of-earnings report, in which an accounting firm takes a deep dive to identify pitfalls that could prevent them from maximizing value. When taking a company to market, we like to show at least 3-5 years of results to prove consistency, tell the story of the company, and show buyers which way key metrics, like EBITDA, are trending.
With any sell-side engagement, it always helps to start working with an investment banking advisor early. Partner with a trusted advisor to provide an accurate picture to potential buyers, enhance value, and get out ahead of any issues that may arise.
Matthew Roberts is Vice President at Copper Run. He specializes in the business services, distribution and manufacturing sectors.