Why re-invent the wheel?
My dear friend and colleague, Chris Mercer, one of the brightest, nationally recognized and most insightful business appraisers of our time, could not have so simply and so precisely stated what so many lay people and experts wrestle with – Why the Focus on EBITDA.? Chris is the founder and CEO of Mercer Capital, a national business valuation and financial advisory firm headquartered in Memphis, Tennessee. Clients include private and public operating companies, financial institutions, asset holding companies, high-net worth families, and private equity/hedge funds. With Chris’ permission I’ve cited key parts of his commentary. If you’d like to read other prolific writings generated from Chris and his firm, just give Marty Abo a shout. In fact why should Abo and Company be the only ones to benefit from Mercer’s pearls of wisdom, try going yourself to www.MercerCapital.com.
Soooo……Why the Focus on EBITDA?
There is a fascination in the business world with something called EBITDA. Look on the audited financial statement of any company and you won’t find any such thing. But everyone, or almost everyone, is talking about EBITDA when they talk about business earnings.
What is EBITDA?
EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is important because, as we will see, EBITDA is the initial source of all reinvestment in a business and for all returns to shareholders. It is essentially the net income of a business adding back the interest expense, income taxes, depreciation and amortization. Abo and Company, Mercer Capital and other financial professionals believe this is especially helpful in analyzing and comparing profitability among enterprises by effectively eliminating the effects of differing accounting methods and differing capital structures (i.e. debt vs. equity decisions).
Starting with Net Income of a company’s financials, interest excpense is removed since it’s usually the particular company’s choice of financing. Income taxes are removed as they vary widely depending on entity structure, acquisitions and losses in prior years which can materially distort the bottom line-net income. EBITDA than eliminates depreciation and amortization with its very subjective selection and judgments that can go into those calculations (i.e. methods used such as accelerated vs. straight-line, useful lives, salvage, etc.)
Professionals around as long as Abo and Mercer saw EBITDA come to the forefront in the 1980s with leveraged buyouts really coming into vogue when we would look to a company’s ability to service its debt. EBITDA has evolved to be especially useful to companies which have or acquired expensive tangible and intangible assets that were being written off (i.e. expensed) over differing and extended periods. As an aside, it’s interesting to see it so focused now by so many companies in high tech industries where its use may not even be particularly relevant or warranted. Proponents of EBITDA typically maintain that it offers a better portrayal of profitability by removing expenses that muddy how an enterprise is really performing.
What’s the Big Deal with EBITDA?
EBITDA is the topmost level of cash flow that is available (or not) for all of the reinvestments that are necessary to enable businesses to grow and to provide returns for owners. Corporate acquirers, private equity investors, investment bankers and valuation analysts all focus on this important measure of cash flow. The next table illustrates in a conceptual way why EBITDA is important to investors.
As businesses grow, it is necessary to reinvest in them. Reinvestment comes first in the form of working capital needed to fund growth in sales. Growing sales normally mean growing accounts receivable and, for companies that make or sell stuff, growing inventories. .
Then, it is necessary to reinvest in the business to replace machinery and equipment, or fixed assets, that wear out with time or become obsolete or out of date because of newer, faster, more productive equipment or software or machinery and on. Further, if a company is growing, it will be necessary to invest in additional plant and equipment or other fixed assets. For distribution companies, these investments may come in the form updating existing facilities or building new locations.
Professional service firms are not usually capital-intensive. The “inventory” they have walks out the door every day and hopefully returns the next. But they do have to finance growing accounts receivable.
If businesses borrow funds to finance operations, it is necessary to pay interest on loans and to repay principal on a timely basis. Lenders want to be paid and so create all kinds of protections for themselves to assure that they will be paid on time.
Next, if there is profit at the end of the day, all businesses must pay their taxes. We have to pay to play the game of business in America.
Finally, if there is any cash flow left after taking care of all of the prior needs of the business, its owners have a chance for cash return. Owners reinvest in a business for the prospects of increasing future returns in the form of appreciation and higher future cash distributions.
So there we have it. Investors and analysts focus on EBITDA because when buying a business or when valuing a business, it is necessary to make judgments about its ability to generate cash flow sufficient to meet all of the needs of the business and to provide adequate returns to shareholders.
One final point: The greater your EBITDA, the greater the value of your company. You can’t say that about sales. You can’t say that about gross profit. But you can say that about EBITDA.
EBITDA is important. So Mercer, only echoed by Abo, asks a few questions:
- What is your company’s EBITDA?
- What is the trend in dollars of EBITDA?
- What is your company’s EBITDA margin?
- What is the trend in the EBITDA margin?
- How does your EBITDA margin compare with your competition?
- Are there some obvious things you can do to enhance your company’s EBITDA?
- What steps are you taking to realize this low hanging fruit?
- Are you focused on improving your company’s EBITDA and its EBITDA margin?