The startup valuation process can be arduous for founders even during good economic times. Those seeking to raise capital in the uncertain economic landscape of 2023 are increasingly finding that EBITDA has come to the fore, according to the Triangle Business Journal.
The EBITDA metric is among the most popular mathematical indicators used to assess a company’s profitability. For investors, it provides a good idea of the company’s financial health and ability to generate cash flow, but accounting firms for startups and insiders say that’s just scratching the surface of its power.
“If I was going to invest, my primary concern would be ensuring that the business had an audited, up-to-date EBITDA analysis,” Joseph Ferriolo, director at Wise Business Plans, told Business New Daily.
How EBITDA is derived: a primer
EBITDA is shorthand for earnings before interest, taxes, depreciation and amortization. By stripping out the effects of nonoperating factors, EBITDA is used to put the focus on the company’s earnings amount before these other expenses.
Below is a brief explanation for each variable.
Earnings: The income or profit of your business.
Before: You eliminate four specific factors from your operational performance (the next four parts of EBITDA).
Interest: Because interest is determined by a company’s financial structure, including the amount borrowed and interest rate, it is stripped out in EBITDA.
Taxes: Because taxes are determined largely by a company’s location and various government decisions, they are removed in EBITDA.
Depreciation and amortization: Because these are both fixed expenses, implying they are unaffected by time or by the volume of “units” sold or number of clients, depreciation and amortization are stripped out in EBITDA.
Depreciation and amortization are deemed the result of accounting decisions rather than reflecting current operational performance. Further, amortization is a form of noncash expense employed to gradually reduce the book value of intangible assets, such as intellectual property, over a certain time period.
Before you start the process of calculating your startup’s EBITDA, your books must be in good order, which an accounting firm for startups can help ensure.
What EBITDA reveals
The EBITDA indicator measures the company’s ability to generate all of its income from its core businesses. In contrast, the net income indicator calculates the company’s total earnings after paying expenses, taxes, depreciation and amortization.
For investors, an advantage of EBITDA versus other metrics is that it allows you to analyze and compare profitability across companies and industries, regardless of size, structure, taxes or assets.
While EBITDA provides a straightforward method to assess a company’s operating performance and has become more important to investors, most financial consultants advise performing a significantly more thorough analysis when considering a startup’s value.
Calculating EBITDA is simple
EBITDA can be easily determined from a company’s financial records, even if it is not explicitly reported there. In fact, all of the information required to calculate EBITDA is provided in the income statement.
The Corporate Finance Institute provides two formulas for calculating EBITDA:
1. EBITDA based on net income
EBITDA = Net Income + Taxes + Interest Expense + Depreciation & Amortization
2. EBITDA based on operating income
EBITDA = Operating Income + Depreciation & Amortization
Company A has $100 million in revenue, and it incurs $20 million on overhead expenses and $40 million on the cost of goods sold. Its operating profit is $30 million after depreciation and amortization costs of $10 million.
The company spends $5 million on interest, leaving $25 million in earnings before taxes. After subtracting $4 million in taxes from pretax income, A’s net income is $21 million (assuming a 20% tax rate and tax-deductible interest payments).
EBITDA formula = Net Income+ Taxes + Interest Expense + Depreciation & Amortization
|Depreciation & Amortization
Company A’s EBITDA
How can EBITDA help measure a company’s ability to generate cash flow?
EBITDA is a simple yet effective metric that will assess your startup’s cash flow from operations. It is considered to be one of the most reliable techniques, along with discounted cash flow, to assess a company’s performance and growth.
A positive EBITDA indicates that the business sells its goods or services for more money than it costs to produce them. A negative EBITDA on the other hand, suggests that the business is suffering losses.
EBITDA also offers investors enough information to gauge the trajectory of a startup’s development, which helps assess the viability of an investment.
What’s considered a “good” EBITDA margin?
Calculating EBITDA is a first step toward helping investors to determine how you stack up against competitors. However, a positive EBITDA doesn’t necessarily mean a company has high profitability.
The EBITDA margin takes the metric a step further by calculating the percentage of EBITDA to revenue. This derives a more accurate assessment of a company’s operating profitability and cash flow than EBITDA alone.
Let’s revisit Company A to calculate its EBITDA margin:
EBITDA ÷ net sales = EBITDA margin
$40 million ÷ $100 million = 40% EBITDA margin
Company A’s 40% EBITDA margin implies that the remaining 60% of sales revenue accounts for its operating expenses, excluding depreciation and amortization.
EBITDA margins can help investors compare the profitability of similar companies. In general, a high EBITDA margin is considered more favorable versus a low margin, because it suggests higher profitability and stability.
On the other hand, a “low EBITDA margin indicates that a business has profitability problems as well as issues with cash flow,” according to the Corporate Finance Institute.
What are EBITDA’s drawbacks?
The EBITDA metric isn’t recognized under generally accepted accounting principles. This is because the metric strips out interest, tax, depreciation and amortization, all of which are included when calculating net income under GAAP.
When evaluating a company’s performance, excluding debt has its own set of disadvantages. To distract from debt and improve the perception of financial success, companies may emphasize their EBITDA margins.
For example, a business may use EBITDA to avoid showing things like aging equipment that will be expensive to replace, or high-interest loans. The EBITDA margin shouldn’t be used to evaluate companies with massive debt.
As the EBITDA margin is higher than the profit margin, companies with low profitability will be tempted to place more emphasis on this figure as a success indicator.
Finally, when calculating EBITDA, companies may use varying earning figures, introducing the possibility of manipulation of account calculations on income statement. The metric can also obscure company valuation, making it look less valuable than it is.
The bottom line
EBITDA provides a good proxy for cash flow, which is a key factor in determining a company’s value. However, it also ignores important expenses and can be misleading. It is vital to consider other financial metrics and factors when evaluating a company’s financial performance.
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