By Vishal Bharucha, president of VNB Business Brokers, a leading business brokerage and M&A advisory firm.
Calculating your business value is a vital part of success. It's even more important than the revenues as they do not matter without profit generation. What's more, it's an indicator of how much money you have left to invest back into your business--which is key to future growth. If you're planning to apply for a bank loan, having a solid net profit is also important as banks use it to assess the suitability of the loan and your ability to repay. Not only can it give you a clear picture of your business' standing from a financial standpoint, but it can also offer your investors the confidence that their money is moving in the right direction.
This article will offer insight into the differences between net earnings, EBITDA and SDE, and how these variables measure business value.
Net profit, or net earnings, is an important factor in determining the success of your business. The formula is simply the amount of money left once you deduct all your business expenses from the total revenue. However, it does not include tax. Since tax is based on a percentage of your net earnings, you can only calculate it once you've arrived at your net profit figure.
The net income is not just the sole metric in valuing your business. There are also Earnings Before Interest, Taxes, Depreciation and Amortization--also known as EBITDA--and Seller's Discretionary Earnings--also known as SDE. But what is the difference between the two, and which one is more suitable for your business?
If net income reflects your company's total earnings, EBITDA indicates the consistent ability of your company to make a profit, hence your business value.
EBITDA is a metric commonly used in medium and large businesses. To have a more in-depth understanding of the variables involved in EBITDA, here's a breakdown of its key terms: interest (expenses caused by interest rates--e.g., bank loans), taxes (federal income taxes and government-imposed taxes), depreciation (non-cash expense of asset value reduction on fixed company assets) and amortization (non-cash expense of intangible assets).
The formula to calculate regular EBITDA is:
Net Income + Interest Expense + Depreciation Expense + Amortization Expense + Taxes
However, businesses are usually valued on several adjusted EBITDA. In an article by Windes, an adjusted EBITDA is often used as a hybrid model when the buyer is a financial buyer and the seller is taking a higher salary than that of a non-owner manager. This is common when the buyer is a Private Equity Group.
Adjusting the EBITDA means removing any one-time expenses to normalize the salary. For example, if you're paying yourself an annual salary of $250,000 but an acquirer can replace you with a manager earning $200,000, you would add $50,000 in excess salary.
SDE is a metric used to track a business's historical cash flow. It is simply your net profit with add-backs. By definition, add-backs are expenses added back to your net profit to improve your business's value. This is a valuation metric commonly used in small businesses. It presents the financial benefits that potential buyers would potentially receive granted that they would be full-time owners/managers.
The key difference between EBITDA and SDE is what it suggests about the performance of your business. According to an article by Midstreet, EBITDA gives your investors an idea of how your business will perform against competitors in the same industry. On the other hand, SDE would indicate to the potential buyer how much they will be earning on a full-time scale. Another big difference, highlighted by Windes, is the inclusion and exclusion of the manager's salary. In EBITDA, the manager's salary is not added back; in SDE, the manager's salary is added back assuming that the potential buyer would replace the seller as the owner/manager of the business.
Having a clear understanding of your business's value based on net earnings, EBITDA and SDE is vital for owners, investors, creditors and buyers. It doesn't just give them the confidence that your business is on solid financial ground, but it also measures operational efficiency.
Accuracy is crucial in calculating these metrics, hence it is important to hire trusted and experienced accountants. An overcalculation or undercalculation may lead to the owner's overspending or underspending, and generate false business value that could impact the sale of your business.