How to Use EBITDA to Value Your Company
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is used to determine the cash earnings without accrual accounting. Within an Income Statement the interest, tax, and amortization account balances are removed to determine a company’s periodic cash earnings. Although a company may eventually have to make payments (in full or a portion) on the balances removed, the EBITDA determines a company’s ability to manage their hard operational costs.
Business owners should know their EBITDA and compare it periodically. An increase in EBITDA could mean a company is able to afford their monthly operational costs more effectively, whereas a decrease could represent a change in operations that is less productive and/ or efficient.
For business owners who are actively pursuing debt financing, they may use their EBITDA to calculate their ability to pay off pre-existing debt and/or additional debt. If a company is not capable of honoring the debts they hold or wish to acquire, one could conclude the company may undergo financial hardship. However, EBITDA represents historical data; it may be possible for a business to increase their sales while maintaining the same costs.
A company’s EBITDA can be used to revise a business plan, or create a new one, as well as structure a corporate budget to ensure higher earnings. A consistently low EBITDA, from year to year, could mean a business is operating with a top-heavy company or that the Costs of Sales are too high. As well, business owners can assess their risks moving forward by reviewing the EBITDA of their operations over several fiscal periods.
Business owners should be cautious with the use of EBITDA to assess the value of their businesses. The following lists concerns with valuing a company solely based on EBITDA:
- Items removed from the Income Statement to calculate EBITDA could be a potential future cash payment for a business; therefore, an individual would not be able to know the net cash earnings in real time.
- EBITDA represents historical data and a company could make changes to drastically change to improve their EBITDA, such as increasing sales, decreasing cost of sales, and/ or decreasing general & admin expenses.
- A favorable EBITDA could also mislead business owners, as it may not address the key components to a business’s previous success.
Realistically, business owners should not rely on one calculation to determine the value of their business; therefore, comparing multiple years is necessary as well as reviewing the net income from year to year. One of the benefits of EBITDA for small business owners is to determine their ability to schedule dividends for the shareholders.
Dividends could be awarded in fiscal periods where the EBITDA is significant; however, it should be paid out after all outstanding interest and tax payments are made. Business owners can reap the benefits from their hard work that could increase morale thus potentially increasing productivity. Financial rewards may entice business owners to be more aware of their operational costs, as well they could be more motivated to sell more products or services.