By Michael French, CPA, ABV, CFE, Managing Director

Financial metrics play a pivotal role in evaluating the potential of a target company and in negotiating favorable terms in a merger or acquisition. Among these metrics, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) stands out as one of the most commonly used and influential figures. EBITDA serves as a crucial indicator of a company's operational performance, financial health and future prospects. Its significance in M&A due diligence and negotiation is paramount, as it provides key insights into a target company's profitability and potential for growth.

EBITDA: What Is It?

It's essential to understand what EBITDA represents. EBITDA is a measure of a company's operating performance, calculated by adding back interest, taxes, depreciation and amortization to net income. By excluding these non-operating expenses, EBITDA provides a clearer picture of a company's core profitability and its ability to generate cash flow from its primary business operations.

How is EBITDA Used?

During the due diligence phase of an M&A transaction, the acquirer examines the target’s financial information to assess the feasibility and risks associated with the target. EBITDA contributes to this process in several ways:

Performance evaluation: EBITDA serves as a key metric for evaluating the target company's historical financial performance. It allows the acquirer to assess the company's ability to generate earnings before accounting for non-operational factors such as interest and taxes, providing a clearer picture of its operational efficiency and profitability.

Comparative analysis: EBITDA facilitates comparisons between target companies operating in the same industry or sector. By normalizing for differences in capital structure, tax rates and accounting methods, EBITDA enables more accurate comparisons of profitability and operating performance, aiding in the determination of potential synergies and value drivers.

Cash flow assessment: EBITDA is closely related to a company's cash flow generation capabilities. During due diligence, acquirers analyze EBITDA to assess the target company's ability to generate sufficient cash flow to service obligations, fund future growth initiatives and provide returns to shareholders.

Financial forecasting: EBITDA serves as a basis for financial projections and forecasts. By understanding the target company's historical EBITDA trends and drivers, acquirers can develop more accurate projections of future performance, enabling better decision-making regarding valuation and investment strategies.

Identifying red flags: Significant fluctuations in EBITDA can serve as warnings during due diligence, signaling potential risks or underlying issues within the target company's operations.

EBITDA in Negotiation

In addition to its role in due diligence, EBITDA also influences the negotiation process in M&A transactions:

1. Valuation benchmark: EBITDA serves as a primary valuation metric in M&A transactions, particularly for companies with stable cash flows and predictable earnings. Acquirers often use multiples of EBITDA (such as EV/EBITDA) to determine the appropriate purchase price for the target company, considering factors such as industry norms, growth prospects and risk profile.
2. Deal structuring: EBITDA directly influences the deal structure and terms negotiated between the parties. Sellers may seek to maximize the valuation by emphasizing their EBITDA performance and growth potential, while buyers may leverage EBITDA multiples to negotiate a lower purchase price or favorable payment terms.
3. Earn-out provisions: Earn-out provisions, which tie a portion of the purchase price to the target company's future performance, often use EBITDA as a performance metric. By aligning the interests of the buyer and seller, earn-out agreements can help bridge valuation gaps and mitigate risks associated with uncertain future performance.
4. Debt financing: EBITDA plays a crucial role in securing debt financing for M&A transactions. Lenders assess a target company's EBITDA as a measure of its ability to service debt obligations and determine the appropriate loan terms.

Takeaway

In summary, EBITDA serves as a cornerstone of M&A due diligence and negotiation, providing valuable insights into a target company's financial performance, cash flow generation capabilities and growth prospects.

Contact

For more information or a discussion about how EBITDA may impact a transaction you are considering, contact your PKF Advisory team member or:

Michael French, CPA, ABV, CFE
Managing Director
Tel: 949.860.9891
Email: mfrench@pkfadvisory.com