EBIT…Huh? What the heck is that?
Say it out loud with me: Eeee – bit – dah.
One more time out loud.
EEEE – bit – daaaah.
Did your co-workers just look at you funny? Good.
EBITDA is short for Earnings Before Interest Taxes Depreciation and Amortization. It is a shortcut to estimate cash flow to the firm. It’s also one of the more common financial measurements used to value firms.
EBITDA approximates the cash the business is generating for all stakeholders (owners, investors, debt provides, etc.).
That is important for an investor to know. When someone invests in your business, they want to know what they are getting in return. EBITDA is a good way to measure that.
The reason EBITDA is so important is that it allows investors to compare different companies with different capital structures, equipment, levels of debt, tax structure, ownership, levels of investment in property and equipment, etc. and normalize them.
Take for example, two shops:
- One has invested heavily in equipment and building out a state of the art facility and is a traditional corporation.
- The other still uses the same frame machine they bought in the 90’s, has not updated their facility since they moved in; and is a pass through S-Corp.
Company A has higher sales ($1.5mm), but also more expenses. Expenses like interest payments for the equipment and facility upgrades plus depreciation expenses and federal taxes since the company is structured as a traditional corporation. Company B has no debt and has already fully depreciated all of its assets so has very little to no depreciation expense and no taxes at the corporate level.
The respective P&L’s would look something like this:
So which is the better investment? Company A has 50% more sales but is much less profitable than Company B. Is the shop that does not invest in equipment or facility with lower sales is worth more than the shop that does make those investments?
That doesn’t seem to make sense.
By analyzing EBITDA an investor (or owner) focuses on the operations of a business rather than investment decisions, financing decisions, tax and accounting decisions.
In other words, EBITDA adjusts for the additional expenses that company A has that company B does not have to get a better understanding of the business.
Looking at EBITDA rather than profits clearly shows that after accounting for the investments in equipment and facility, company A is clearly the superior company.
EBITDA is important and it drives value. If you are considering a sale, or even just want to run a better business, don’t look profits, look at EBITDA.
Until Next Year – One last time:
EEEE – bit – daaaaaaaah.