What is EBITDA and is it important to know when buying a business?
Many people buy businesses or invest in companies with no idea of these basic financial terms and what they mean.
EBITDA , stands for earnings before interest, taxes, depreciation and amortization, and is one metric to determine financial performance of a company. EBITDA is the companies earnings with those variable expenses, interest, taxes, depreciation and amortization, backed out. Why is that important? One reason to look at EBITDA is it eliminates the variables of financing and capital expenditures. For example if the present owner has a substantial loan, and you only look at the net profit, you wont have an accurate representation of what your profits might be if you are buying the business with no financing, or if you do have financing, your terms and amounts will likely be different than the current owner. If you are comparing companies from an investing perspective, EBITDA allows you to compare companies on a more level playing field with these variables of loan interest, depreciation and amortization backed out. That said, EBITDA does make it easier for companies, particularly tech companies, to look much better on paper than they actually are, and the SEC does not consider EBITDA as a generally accepted accounting principle. So be sure to understand the limits of EBITDA before making any decision. EBITDA is often confused with Net income, which is quite different and calculates the total earnings of the company *after paying the taxes, depreciation, and amortization.
So then is net profit the best figure to look at if you are buying a business? Most inexperienced buyers think that net profit is the only number you need to look at. Not necessarily because with a small business a company could have a very small net profit, lets say $6,000 a year. Based on that small net profit most buyers would think that is not a good business to buy. But when we dig deeper and look at *discretionary earnings we see that the owner took a salary of $100,000 a year, that money went into the owners pocket, but remember the owners salary is actually an expense for the business, same as all other employee salaries. They also may have paid for fuel with company money for themselves or family members for business trips, they may have made charitable contributions. All of these have direct owner financial benefit but wont show up in net profit.
There also may be one-time non-recurring expenses that will skew net profit in a given year. So for example if a bakery or pizza shop had to replace an expensive oven after 10 years, that is likely not an expense you have to worry about in the near future. So in this case a business that did not show well at only $6,000 profit, when we look at seller discretionary earnings we see that actual owner benefit was a $100k a year salary, fuel, trips and an expensive oven, which demonstrates almost $150,000 a year going to the owner. So net profit is not always the end of the story. Conversely, if the business shows a higher net profit, but no salary was taken by the owner as is often the case in startup, or if repairs or replacement of equipment may be needed in the near future, net profit may make the business look better than it is.
Usually for businesses under 1m in revenue it is prudent to consider Sellers discretionary income vs EBITDA
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