Throughout the years, we have examined the definition of a number of key M&A and financial terms. However, one that we have not spent much time on is probably the one that, in some circles, matters the most: EBITDA.
EBITDA stands for earnings before interest, taxes, depreciation and amortization. EBITDA is one indicator of a company's financial performance and is used as a proxy for the earning potential of a business.
The literal formula for EBITDA is:
EBITDA = Net Profit + Interest +Taxes + Depreciation + Amortization
EBITDA is essentially net income with interest, taxes, depreciation and amortization added back to it. EBITDA can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions.
This final sentence is the key reason behind the use of EBITDA as a vital earnings gauge. By eliminating the vagaries between financing and accounting decisions, which can vary dramatically from company to company, it allows buyers to make comparisons more accurately when analyzing multiple acquisition opportunities.
For multiple reasons! First, you want to use accurate EBITDA numbers. It never ceases to amaze our deal teams when they encounter an engagement of a fairly large company that has poor financial reporting and analysis systems in place. There really is no excuse for this today with the myriad of relatively inexpensive accounting systems available on the market. Make the investment today in a quality accounting system.
Secondly, after you have accurate historical financials (at least three years, preferably five), you then need to recast your revenue and earnings to truly reflect the profitability of the company. Let’s face it, for years you and your accountant have been legally suppressing earnings to reduce tax liability by writing off a number of legitimate, yet discretionary, items. Vacations, automobiles, boats, planes, and season tickets are just some of the ways that earnings can be understated. Again, all legal, but, before you can demonstrate how truly profitable your company is, you have to remove these items so you can show it.
Finally, since EBITDA is the language used by most professional buyers, the kind of buyers you want to attract to your company, it is important to present your documentation in a way that matches what they like to review. Again, it allows them to make accurate comparisons across multiple targets.
Interested in learning more about this topic? Then you need to attend a Generational Equity executive exit planning conference. We hold these throughout North America and they are designed to educate business owners on the intricacies of exit planning and how to present their companies in the best light to buyers.
To learn more, call us on 972-232-1121 or visit our contact page, provide us with your information, and we will be in touch. Business owners that attend nearly unanimously agree that what they learn in a few hours with us is priceless in terms of exit planning.
By Carl Doerksen, Director of Corporate Development at Generational Equity.
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