There's no good reason to care about EBITDA, right? Wrong. Your banker and investors will care--so should you.
If you’ve sold a business, tried to sell your business, or tried to get a capital investment at an established company, you’ve probably been asked about your EBITDA. “What is that?” is usually the first question of business owners.
What is EBITDA? EBITDA stands for Earnings before Interest, Taxes, Depreciation, and Amortization, and it’s basically a calculation that attempts to take out costs that are not related to a business’s intrinsic value. Bankers, investors, venture capitalists, and private equity firms use it to approximate cash flow–which is the true driver of value creation in your business. The problem is that cash flow can be affected by a number of items not related to the business’s value. For example:
Tax payments can be lumped into one year or the next driven by the need to minimize your tax bill rather than the nature of your business, and can be easily managed through creative tax structuring unrelated to a business’s value.
The level of debt a company uses has a direct impact on net income and can distort free cash flow if not removed. How a company chooses to finance itself should not affect its inherent value.
Depreciation and amortization charges are non-cash items that are not true cash outflows.
Why does EBITDA matter? The primary goal of bankers, venture capitalists, and other investors is to predict FUTURE cash flows from the business. These cash flows drive the appropriate valuation of the business, but also affect the business’s ability to service acquisition debt, and generally fund a company’s operations.
Bankers and investors want to use historical financials to predict future cash flows, because it’s the most objective measure they have at their disposal. Note that we didn’t say it was the BEST way to value a company, just the most objective.
Everyone knows that entrepreneurs and CEOs are inherently optimistic but want to take at least some of the opinions and biases out of the equation, even if the result is a measure that in many ways is suboptimal.
Why should you care about EBITDA? From our perspective, no CEO or investor that wants to maximize long-term value should pay much attention to EBITDA. It’s not the best measure of value creation in a single year (economic profit, or profit after a charge for the opportunity cost of capital, is a better metric), nor is it the best measure of cash flow (which can be calculated by taking net income minus any increase in capital usage). The only reason EBITDA matters to the management team is because it matters to outside capital providers.
If you are looking to sell your company, raise capital, or even buy another company, you will likely have to justify the company’s EBITDA to prove your attractiveness to investors or acquirers. When a sale, financing or acquisition is on the horizon, it’s important to take stock of your EBITDA and do what you can to improve it.
KARL STARK AND BILL STEWART are managing directors and co-founders of Avondale, a strategic advisory firm focused on growing companies. Avondale, based in Chicago, is a high-growth company itself and is a two-time Inc. 500 honoree. @karlstark