EBITDA (pronounced “ee-bit-dar”) stands for Earnings Before Interest, Taxation, Depreciation and Amortisation.
Yes it is a bit of a mouthful in long form but the concept is vital when comparing business performance and also looking at business valuation.
In short it is an adjusted net profit figure that business valuers use to assess the value of the goodwill element of your business.
Your business goodwill is the non tangible element of your business. In essence it is how much someone will pay as a premium for your business over the current value of the net assets in your business.
It includes everything bar your physical fixtures and fittings which are valued separately.
Your goodwill includes how well you retain and grow your customer base and your reputation in your industry.
In a nutshell, goodwill is a value placed on the future profitability of your customers.
To value your goodwill, valuers extract certain elements from your net profit figure such as the interest you pay on the loans you have and any depreciation applied to your long term assets. This is because these factors are specific to you and do not necessarily apply to an incoming business owner. Hence why EBITDA is Earnings Before Interest, Tax, Depreciation and Amortisation
A multiple of this adjusted net profit figure, or EBITDA, is then used to value your business. That multiple depends on a lot of factors but is typically industry specific.
Even if you do not want to sell your business in the short or even medium term a proactive accountant will calculate your EBITDA for you on a regular basis.
Because knowing and monitoring your EBITDA to be able to grow it over time not only allows you to extract more cash from the business but it will also improve the value of your business when you do come to sell.
Why will knowing EBITDA increase the value of my business?
If there is one thing that you should look at (apart from cash) it’s EBITDA, because if it’s not big enough then your business will never grow, ever.
Why won’t my business grow?
If you don’t have a big enough EBITDA then you won’t be able to fund that growth.
Because growth comes from investment and the majority of investment comes in the form of capital expenses (equipment etc) or loans to fund additional operating expenses or indeed, sometimes a mixture of both.
With that equipment comes depreciation and with those loans comes interest.
So you need to know just how much profit you have before depreciation and interest to understand how much you can afford to invest.
Simples as a meerkat would say….
Now some businesses don’t need to worry about capital expenses (CapEx) as they don’t need huge investments in equipment to grow, for example recruitment firms, consulting firms, designers, estate agency, etc. These types of businesses sell their time, they provide a service and hence when they look to grow their expenditure increases before turnover does.
They buy capacity in the form of people and this is their biggest expense.
People then need space and they may need a bigger office. A bigger office means bigger light and heat bills, rates etc and their occupancy costs grow. So the increases in costs are operating expenses (OpEx), the costs that occur in the general nature of doing business day by day.
Now good businesses owners and their teams know how to control OpEx, but very few monitor want they are spending against what they thought they could spend.
Even fewer adjust there OpEx in line with changes in revenue, but this is where the savvy smart entrepreneur has an advantage – from their understanding of this relationship. That’s a completely different subject though and one for another time.
Let’s get back to EBITDA
EBITDA (to reiterate) is Earnings Before Interest Tax Depreciation and Amortisation.
It’s important because it shows the investors (the shareholders – that’s ostensibly you) just how much of a return can be made if the financing and investment changed in the business.
It strips out interest, tax, depreciation and amortisation from Net Profit in order to show just how well you are OPERATIONALLY running the business.
It is this operationally performance that should be used to monitor the health of your business and not Net Profit as this is often distorted by how your business is financed.
EBITDA effectively is a shortcut to estimate just how much profit you have available to pay debt and acquire new assets. It is these debts and the assets which are used generate income in your business. Hence without this investment then your income will stagnate and you simply won’t grow.
EBITDA provides a snapshot of the short term operational efficiency of your business. This is why a positive and healthy EBITDA is so important and why it will make you and could (unless monitored) break you.
EBITDA will show just how good your business will perform when tucked up inside a larger business that can finance is better. And this is why it is used to value your business.
So as your business is your largest asset (besides maybe your house) then why wouldn’t you make it as efficient as possible for someone else, and show them just how profitable it could be to them.