What is EBITDA (and why should I care?)

I had a question from a business owner recently during a talk I was giving. “What is EBITDA” he asked, and then added, “and why should I care?”

The answer to the first question is that EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization.

Why is this important to a business owner? Two reasons come to mind:

1. EBITDA is a good proxy measure for operating cash flow. By removing depreciation and amortization (non-cash charges), interest (a financing item) and taxes (which are paid from profits after interest, depreciation and amortization), you get a quick measurement of (pre-tax) cash flow from operations. This differs from the cash flow that your accountant presents on a statement of cash flows in your financial statements because the statement of cash flows shows, in addition to cash flow from operations, the statement of cash flows shows the cash flows related to investments in your business and the cash flows related to financing activities.
2. If you want to know what your business is worth to a buyer, EBITDA is often used for a rule-of-thumb gauge. In talking with investment bankers, one will often hear them refer to the value of a privately held company as “4 to 6 times EBITDA.” A few words of caution in interpreting this statement, however. First, investment bankers don’t always say it this way, but they generally mean “Adjusted EBITDA.” In other words, EBITDA adjusted for unusual or one-time expenses, and for owner compensation, perks, and benefits (if higher than market). Second, the “4 to 6” times range is a very rough measure. Smaller companies (EBITDA less than $1.5 million) may sell for less than 4 times adjusted EBITDA, especially if they are not growing. Privately held companies with EBITDA over $2 million, and whose revenues are growing at double-digit rates may command more than 6 times adjusted EBITDA.

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