By Fabio De Filippo, CPA

One of the first factors to consider when planning for the eventual sale of your company is the entity’s estimated value, or the amount a buyer is willing to pay for the business’s assets, liabilities, and all the risks associated with that purchase. While there are many valuation methods for making this determination, EBITDA (“earnings before interest, taxes, depreciation and amortization”) is the preferred metric that buyers, bankers and investors use to value a company and negotiate a sales price.

Many private companies maintain their books using the cash basis of accounting, recognizing income when it is received and deducting expenses when they are paid. This method is easy for small to mid-size businesses to use and track their cash flow while also aligning with federal tax laws and the ways business owners file their returns and calculate their tax liabilities. However, this method fails to address several key factors of a business’s value, including accounts receivable and accounts payable, and it enables owners to take advantage of credits and deductions to reduce taxable income and minimize tax liabilities. This may provide prospective buyers with a distorted picture of a company’s true profitability and its long-term financial stability.

By contrast, EBITDA (provides a normalized view of a company’s earnings and profitability from its primary business operations, excluding the effects of financial and accounting decisions on other aspects of the business, which include the following.

• Interest paid on loans and other debt;
• Taxes (federal and state); 
• Depreciation expenses that account for aging and reduction in value of tangible property, such as buildings, equipment and inventory; and
• Amortization expenses for intangible property, such as patents, trademarks, licenses and lease agreements.

EBITDA, therefore, focuses squarely on a company’s core financial performance, stemming from operational decisions and its earnings potential, without consideration for non-operating expenses that can vary from month-to-month or year-over-year. This assessment of operating profitability helps business owners evaluate the overall financial health of their businesses, including their cash flow and ability to meet short-term financial obligations and finance future growth. It also enables them to identify emerging trends or risks that can impact their ongoing operations and profitability.

From the perspective of lenders, investors, and potential buyers, EBITDA provides a standard metric for measuring meaningful business value and comparing how a target business stacks up against other companies of comparable size and in similar industries with different capital structures, accounting methods, and tax liabilities. To determine a particular business’s value or purchase price, a multiple of EBITDA is applied based on a wide range of factors, including economic market conditions, the competitiveness of the industry, the target business’s size, location, strength of its management team, its competitive advantages, and its known or perceived weaknesses.  

To calculate EBIDTA, business owners must maintain accurate and GAAP-compliant financial statements and have at the ready three to five years of historical economic data to avoid delays in a prospective deal closing. This must include timely closed monthly financial statements, documentation to support non-operational and non-recurring expenses, and current-year budgets and forecasts out two to three years into the future. Having this information in hand, along with a quality of earnings (QOE) report, further helps business owners identify risks, inefficiencies, and areas where they may reduce unnecessary expenses and find opportunities to increase profitability, which can yield a potentially higher sale price.

It is the business’s responsibility to pinpoint its unique value proposition, whether that includes high margins, low customer churn, modest fixed costs and/or the potential of future earning streams. Additional factors that can drive company valuations and purchase price multiples include the depth and quality of the management team, healthy profitability and EBITDA margins, the “stickiness” and recurring nature of the entity’s revenue, upside growth potential of the company and the level of capital being reinvested back into the business.

For more information contact:

Fabio De Filippo
Managing Director
Tel: 646.213.7596
Email: fdefilippo@pkfadvisory.com