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What is EBITDA?
It’s not the acronym that rolls most easily off the tongue, but EBITDA (pronounced eeh-bit-dah) is an extremely useful valuation metric for growing businesses that can help inform prospective buyers of, or investors in, a company.
EBITDA stands for earnings before interest, tax, depreciation and amortisation, and is commonly used as an indicator of a business’ performance and growth potential.
It is a figure that adds together all your business’ net earnings, with the amount of money you lose through taxation, interest on debt repayments and the amount of value lost over time of both tangible and intangible assets (we’ll get onto what these are in a moment).
First, let’s define some terms:
Your earnings are defined as your business’ net profit as reported to HMRC in your corporation tax return. This is equivalent to the total revenue you’ve generated from all sales of goods and services, minus all legitimate, expensable business costs.
This is the amount your business spends on the interest incurred as you repay debts. This figure is added onto your net earnings.
The amount of taxes that your business pays are added into the final EBITDA figure and this amount can change year-to-year, depending on both the performance of your business and government policies.
This refers to the value of tangible (physical) assets. Over time, tangible assets such as machinery or vehicles will usually fall in value. The amount of value lost over time (the depreciation value) is included in the EBITDA calculation.
Similar to depreciation, amortisation refers to the loss in value over time of intangible (non-physical) assets of a business. Examples of intangible assets whose value will amortise include patents, trademarks, software and copyrights.
How to calculate EBITDA
The main formula to calculate EBITDA is:
EBITDA = Net Income + Interest Expense + Taxes + Depreciation + Amortisation
Quite simply, the final EBITDA value is calculated by adding all the relevant parts of the equation together. For example:
There is an alternative formula for calculating EBITDA:
EBITDA = Operating Income + Depreciation & Amortisation
In this formula, operating income is simply considered to be total sales less operating expenses, such as wages and cost of goods sold (COGS). This figure is calculated before taxes and interest payments are deducted.
These two formulae can yield slightly different results, simply because net income includes certain items that might not be included in the operating costs calculation, such as one-time expenses.
Debt to EBITDA ratio
Put simply, this metric is a measure of a company’s ability to pay off its debts. The higher the debt to EBITDA ratio, the more likely it is that a business is considered likely to default on its debts.
The calculation of your business’ debt to EBITDA ratio is simply your gross debt, divided by your EBITDA valuation.
A key metric used by investors to compare businesses with their peers and competitors is known as the EBITDA margin. This is simply the business’ EBITDA value divided by its total revenue.
EBITDA multiples by industry
In simple terms, EBITDA multiples are a way of comparing different businesses taking into account factors like growth potential, industry and size. They are often used by startup businesses and their investors to plan their exit valuation.
In most circumstances, industries which are regarded as having higher potential for future growth will have higher EBITDA multiple values. Also, larger, more established companies will usually have higher multiples than smaller businesses. This allows investors to more accurately calculate risk.
The startup valuation platform, Equidam, lists the typical EBITDA multiples for various example industries, including:
|Advertising and marketing||12.74|
|Biotechnology and medical research||18.61|
|Management consulting services||17.28|
|Textiles and leather||21.19|
|Food retail and distribution||9.59|
|Hotels and cruise lines||30.7|
|E-commerce and marketplace services||44.21|
Who uses EBITDA?
When you apply for a business loan for your existing business (as opposed to a startup loan), your bank will likely use your EBITDA calculation to determine whether or not to lend you money, based on their assessment of your company’s ability to pay its debts.
Typically, banks will look for a EBITDA cash flow of 1.25 times the loan payments for businesses with real estate and 1.5 times the value of the loan payments (known as debt service) for businesses without any real estate.
However, it is not uncommon for some banks to look for an EBITDA value of two times the loan payment value to secure the loan.
When investors are deciding on whether or not to put capital into your business, EBITDA is one metric that they will often use to judge their potential investment is a business’ EBITDA margin. The higher your EBITDA margin, the more attractive you may appear to investors.
This metric is also used to compare your business to your peers and competitors in the eyes of the investors.
You should be aware that investors will also look at a number of other metrics, aside from EBITDA, when judging whether or not to invest and EBITDA is not the be all and end all of your business’ chance of gaining investment.
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This content has been created for general information purposes and should not be taken as formal advice. Read our full disclaimer.
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