Understanding EBITDA; How To Calculate Earnings Before Interest, Taxes, Depreciation & Amortization

The article below is written by Viking M&A, and it goes over EBITDA. EBITDA is the primary metric for determining a business’ true profitability and cash flow. We see most good businesses in the lower middle market selling between 3-5x EBITDA. This is known as a multiple, and it can be adjusted up and down based on specific factors of each individual business. Some positive multiple increases occur when a business has strong recurring revenue, consistent annual EBITDA, or good opportunities to grow. Some factors that would hurt a multiple would be keyman risk, customer concentration, or a cycle business model.

WHAT IS EBITDA? WHAT IS IT USED FOR?

EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. EBITDA is one of the indicators our firm uses in determining the value of a business, as well as its future financial performance and earning potential. EBITDA is net income with interest, taxes, depreciation and amortization added back, and is used as a calculation for determining the cash flow of the business. At Viking M&A, our experienced financial analysts use this proxy in calculating the value of a business. An EBITDA analysis is essential when comparing similar companies within a single industry during the valuation process.

Let’s look at the aspects involved in an EBITDA calculation:

INTEREST

Interest expense is found on a company’s income statement or profit and loss statement and is added back in our valuations. Interest is a non-operating expense and will differ between individuals. The interest expense line item can consist of interest from loans, lines of credit, or other forms of debt. In order to perform an accurate valuation, we always ask business owners to provide us with appropriate financial statements which will include interest expense. These include the last two years of federal tax returns, two years of Profit & Loss Statements (P&L) including balance sheet, and interim financials.

TAXES

At Viking, we use the net income on the first page of the tax return and only add back items that have been expensed from that net income. This includes the expenses listed on the first page and expenses on the Other Deductions Statement. The tax portion of EBITDA rarely comes into play in our valuations because of this. However, when looking at a P&L, estimated tax payments to the State or Federal Government will be part of EBITDA.

DEPRECIATION

To understand depreciation, you must first recognize the importance of fixed assets. Fixed assets are tangible assets, meaning that they have a physical form and can be touched. Tangible assets include equipment, machinery, land, etc. Depreciation involves the expensing of fixed assets over its useful life. Useful life is the predicted lifespan of a depreciable fixed asset. Depreciation is a non-cash expense that restores the cost of a fixed asset.

AMORTIZATION

Amortization involves the expensing of intangible assets rather than tangible assets. Intangible assets are non-physical assets that include goodwill, copyrights, patents, trade names, customer lists, franchise agreements, etc. These assets are included on a company’s balance sheet and have a multi-period useful life. Intangible assets are typically difficult to evaluate compared to fixed assets.

CALCULATING EBITDA

Calculating EBITDA involves reviewing a business’s income statement and can be expressed in two different ways:

  • EBITDA = Earnings + Interest + Taxes + Depreciation + Amortization

  • EBITDA = Operating Profit + Depreciation + Amortization

Both calculations result in the arriving of EBITDA.

Please visit Viking M&A for more information on business valuation and other M&A topics.

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