EBITDA, an acronym for Earnings Before Interest, Depreciation & Amortization, is one of the most widely used terms in the world of business valuation, mergers & acquisition, and financial analysis. One hears all the time that businesses are priced as a multiple of EBITDA—e.g. five times EBITDA. Why is EBITDA used this way and what does it really mean?

Income statements that are prepared in accordance with Generally Accepted Accounting Principles (GAAP) typically culminate in Net Income which is the “bottom line” on the income statement and also the “Earnings” part of EBITDA. Net Income is an accounting concept which attempts to match income and expenses with an appropriate accounting period. Therefore, for example, depreciation and amortization are ways of recognizing the cost of a long-lived asset over a period of years roughly equal to its useful life. However, depreciation and amortization are “non-cash” expenses on the income statement—since EBITDA is meant to be a measure of cash flow, those items are “add-backs” in determining EBITDA.

What about Interest and Taxes? Since in most business acquisition transactions the buyer purchases the business assets only, the existing debt in the business will not affect the buyer’s cash flow. The buyer will have his or her means of financing the acquisition by some combination of equity and debt. Also, buyers will make their own tax calculation based on their own situation and do not need to consider the seller’s tax rate. As a practical matter, most businesses are so-called “pass-through” entities that do not pay an entity level of tax, so it is not an issue.

A buyer considering a business purchase will attempt to measure future cash flow. After all, it is the future cash flow that the buyer is acquiring. Obviously, this cannot be known precisely, but the buyer’s financial modeling will attempt to estimate it as well as possible.

EBITDA is a rather crude measure of cash flow and is never used by itself to value a business. The nature of the business makes a big difference. For example, a manufacturing business is usually capital intensive and equipment purchases will have a big impact on cash flow. A service business on the other hand will need less in the way of equipment purchases. For a growing service business, a major drain on future cash flow might be the need to hire new employees and the lag in cash flow they represent until the revenue they generate is billed and collected.

Another important determinant of future cash flow is the working capital needed to support the business. Growing businesses usually need increasing amount of working capital—inventory gets bigger, receivables usually increase at a greater rate than payables. In looking at the historical records of a growing business, we can calculate the rate of increase of non-cash working capital—that is the working capital, defined as current assets (not including cash) less current liabilities. The future increase in non-cash working capital will need to be financed either from profits from the business or some other source.

So a better measure of cash flow would be: EBITDA less capital improvements less increase in non-cash working capital.

Finally, a buyer must consider how the business acquisition transaction will be financed. If the buyer is planning on using his or her cash, then the analysis is complete—the expected cash return on investment can be computed. However, most acquisitions involved some portion of third-party financing from a bank or other lender. The interest rate and other financing terms will depend on the type of collateral available (e.g. hard assets, such as machinery, or receivables), the perceived riskiness of the business, and the buyer’s financial strength. Leveraging a business acquisition, especially now when interest rates are very low by historical standards, can greatly improve the buyer’s return on the equity investment in the transaction. Of course, a portion of the business cash flow will be used to cover debt service. This will reduce the amount of cash flow available to the owners, but increase the return on the smaller equity investment.

In a business acquisition, the buyer is principally interested in the cash flow that can be taken out of the business and the return on investment that this cash flow represents. EBITDA is merely the beginning of this analysis.

Published in Business2Business magazine (Lancaster edition), November 2014