Why the Focus on EBITDA?

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There is a fascination in the business world with something called EBITDA.  Look on the audited financial statement of any company and you won’t find any such thing.  But everyone, or almost everyone, is talking about EBITDA when they talk about business earnings.

What is EBITDA?

EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization.  It is important because, as we will see, EBITDA is the initial source of all reinvestment in a business and for all returns to shareholders.

We will use two sample income statements to show what EBITDA is and why market participants and business appraisers think it is so important for your company.  Sample Company 1 is a company that sells or makes stuff, so there is an item called cost of goods sold on the income statement.  Sample Company 2 is a professional services company that delivers services.  Both companies are assumed to be S corporations, or tax pass-through entities where the shareholders are responsible for their respective shares of taxes on their companies’ earnings.

Companies Having Cost of Goods Sold

Let’s assume Sample Company 1 is a manufacturer with a few patented products in its portfolio.  We can look at the income statement and learn a bit about the business.

Income Statement Sample Co. 1

Total cost of good sold, including depreciation, total 60% of revenues, so the gross profit is $20 million and the gross margin (gross profit as a percentage of sales) is 40%.  Operating expenses total 29% of sales, so the pre-tax margin is 11.0% and net income, after state taxes, is $5.2 million, or 10.3% of sales.  Not every manufacturer has 10.3% margins, so the patented products must be providing some margin protection.

Where is EBITDA on the income statement?  Well, it isn’t there.  To “find” EBITDA on Sample Company 1’s income statement, we have to do a bit of rearranging:

EBITDA for Sample Co. 1

The derivation of EBITDA is straightforward.  EBITDA is developed by beginning with pre-tax income and then adding the IDA, or interest, depreciation and amortization.  Since we started at pre-tax income, this measure of cash flow is before taxes, as well.  So there we have EBITDA for Sample Company 1 at $9.5 million and with a 19.0% EBITDA margin.

Companies That Deliver Services

Sample Company 2 is a professional services business, let’s say a consulting firm of some kind.  Its income statement is somewhat different from that of Sample Company 1 in that there is no item called cost of goods sold.  Sample Company 2 pays its professionals and support personnel and collectively, they deliver consulting services to clients.  The other expenses for a professional services firm tend to be those of occupancy and everything else.  So the income statement looks as follows:

Income Statement Co. 2

Sample Company 2 expended 58.0% of sales on personnel costs, and 10.0% of sales on occupancy expense. All other expenses, including a small amount of depreciation, totaled 10.5% of sales.  So this professional services earned pre-tax income of $5.4 million, or 21.5% of sales.  Often, professional services firms will spend about 60% of sales on people costs, 20% on everything else, leaving about 20% (pre-tax) for owners.

Once again, where is EBITDA?  We have to derive it as with Sample Company 1:

 EBITDA Sample Co. 2

As before, we begin with pre-tax income and add interest expense, depreciation and amortization (none), and Sample Company 2 has EBITDA of $5.75 million with a 23.0% EBITDA margin.

What’s the Big Deal with EBITDA?

EBITDA is the topmost level of cash flow that is available (or not) for all of the reinvestments that are necessary to enable businesses to grow and to provide returns for owners.  Corporate acquirers, private equity investors, investment bankers and valuation analysts all focus on this important measure of cash flow.  The next table illustrates in a conceptual way why EBITDA is important to investors.

Uses of EBITDA

As businesses grow, it is necessary to reinvest in them.  Reinvestment comes first in the form of working capital needed to fund growth in sales.  Growing sales normally mean growing accounts receivable and, for companies that make or sell stuff, growing inventories.  For further discussion of the accounts receivable component of working capital, see my post Accounts Receivable Management: 9 Thoughts to Add Value to Your Business.

Then, it is necessary to reinvest in the business to replace machinery and equipment, or fixed assets, that wear out with time or become obsolete or out of date because of newer, faster, more productive equipment or software or machinery and on.  Further, if a company is growing, it will be necessary to invest in additional plant and equipment or other fixed assets.  For distribution companies, these investments may come in the form updating existing facilities or building new locations.

Professional service firms are not usually capital-intensive.  The “inventory” they have walks out the door every day and hopefully returns the next.  But they do have to finance growing accounts receivable.

If businesses borrow funds to finance operations, it is necessary to pay interest on loans and to repay principal on a timely basis.  Lenders want to be paid and so create all kinds of protections for themselves to assure that they will be paid on time.

Next, if there is profit at the end of the day, all businesses must pay their taxes.  We have to pay to play the game of business in America.

Finally, if there is any cash flow left after taking care of all of the prior needs of the business, its owners have a chance for cash return.  Owners reinvest in a business for the prospects of increasing future returns in the form of appreciation and higher future cash distributions.

So there we have it.  Investors and analysts focus on EBITDA because when buying a business or when valuing a business, it is necessary to make judgments about its ability to generate cash flow sufficient to meet all of the needs of the business and to provide adequate returns to shareholders.

One final point: The greater your EBITDA, the greater the value of your company.  You can’t say that about sales.  You can’t say that about gross profit.  But you can say that about EBITDA.

Concluding Questions

EBITDA is important.  Let me ask a few questions:

  1. What is your company’s EBITDA?
  2. What is the trend in dollars of EBITDA?
  3. What is your company’s EBITDA margin?
  4. What is the trend in the EBITDA margin?
  5. How does your EBITDA margin compare with your competition?
  6. Are there some obvious things you can do to enhance your company’s EBITDA?
  7. What steps are you taking to realize this low hanging fruit?

The focus by market participants, investment bankers and valuation analysts on EBITDA is clear.  My final question is this:

Are you focused on improving your company’s EBITDA and its EBITDA margin?

As always, contact me by phone (901-685-2120) or email (mercerc@mercercapital.com) if you have questions or want to talk about valuation or management and ownership transition matters in complete confidence.

In the meantime,

Be well!

Chris

 

Please note: I reserve the right to delete comments that are offensive or off-topic.

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