Net Income Does Not Equal Operating Cash Flow
Although business owners may view net income as a key measure of firm profit, it's important to note that buyers frequently use an alternate measure of profit to analyze operating performance. Due to factors such as accrual accounting and a management team's strategic discretion, net income may obscure the view of a business’s operating efficiency and create comparison challenges if reviewing net income of businesses across an industry.
To address net income’s inconsistencies, a financial metric called EBITDA (pronounced “ee-bit-dah”) is used to neutralize the effects of accrual accounting and management decisions. EBITDA is an acronym that stands for earnings before interest, taxes, depreciation and amortization. By adjusting net income to arrive at EBITDA, we create a cleaner view of a business’s operating cash flow than we can glean using net income.
A Business is Valued Based on its Cash Flows
Why should a business owner care about operating cash flow? A company's operations can be simplified to a series of cash flows that are generated by an economic activity, such as providing a good or service. The price the market is willing to pay for those cash flows is based on factors such as the cost of generating the cash flows, the relative level of cash flow (i.e. the margin) and the growth of the cash flow.
Thus, cash flow measurement and reporting is important because it is the basis for valuing a company. Most business valuations are expressed as a multiple of EBITDA. For example, a business with $4 million of EBITDA that is purchased for $20 million would be valued at five times EBITDA.
What’s behind the calculation?
Even though EBITDA is a commonly used measure of operating cash flow, it’s not a metric found on the income statement. Fortunately, the component parts are available on the income statement. To calculate EBITDA, start at the bottom of the income statement with net income, and add back interest expense, taxes, depreciation and amortization. We'll cover detail related to why these items are added back, but first let's review an example calculation.
In the example below, we locate net income of $770,000 at the bottom of the income statement. Then we add interest expense of $125,000, taxes of $330,000 and depreciation of $275,000 to arrive at an EBITDA of $1,500,000. In this example, the company does not have amortization expenses. If amortization expenses were to appear on the income statement, those would have been added back, too.
Interest and Tax Add Backs
Why do we add back interest? If we compare two businesses, one that has borrowed money to fund growth, and the other that has funded growth with equity, the business with debt will have interest expense and will therefore appear to be less profitable, even though the interest expense has nothing to do with the operations of the business. Instead, the interest expense represents the management team’s discretion in choosing a capital structure.
Similarly, taxes are in many cases a function of management strategy. For instance, entity structure, accounting methods or capital structure may impact the tax rate. EBITDA attempts to neutralize the effects of non-operating management discretion and measures only the performance of the company’s operating cash flow.
Depreciation, Amortization and The Impact of Accrual Accounting
Depreciation and amortization are accounting allocations of capital expenditures. If we assume an asset, such as a machine, is purchased for cash, the day the purchase is complete the business will turn over 100% of the purchase price in cash to the seller of the machine. Instead of showing that expense in one period on the income statement, which would distort profit in that period since machine purchases are not an everyday operating expense, accountants can spread the expense over the life of the asset.
But remember that the cash goes out of the door on day one, while the expense is distributed across a period of years. Recognizing the expense over the useful life of the machine is a more accurate allocation of the cost of the machine and also offers tax benefits in the form of lower reported income in future periods. Because depreciation is an accounting allocation and not a cash expense, it is added back to EBITDA.
One shortcoming of EBITDA is that it does not offer an assessment of the level of assets required to generate the EBITDA. Remember, EBITDA is derived from the income statement, so activity that takes place outside of the income statement is not reflected in EBITDA. Investors must review the balance sheet or cash flow statements to discern the level of assets that are purchased or owned, and that are required to generate EBITDA.
Add Backs to EBITDA
It’s not uncommon for sellers to add back non-operating items to arrive at Adjusted EBITDA. Examples of expenses that may be considered for Adjusted EBITDA are excess owner compensation (i.e. compensation greater than market rate salary or bonus), non-operating income, litigation expense, or other expenses that are one-time in nature and that don’t reflect the continuing needs of the operations. As a simple rule of thumb, if the delivery of a product or service relies on a particular expense item, and if removing that item would impact the ability to produce the product or service, then the expense is likely not a candidate for adding back to Adjusted EBITDA.
Sellers should note that forming valuation expectations based on Adjusted EBITDA can be risky if adjustments are not accepted by the buyer. It’s typically a good practice to review add backs with an accountant or finance team member to determine whether the add back is warranted.
Concluding on EBITDA
Businesses can be analyzed as a series of cash flows and buyers typically value businesses based on these cash flows. To normalize comparisons across businesses, EBITDA is used as a proxy for operating cash flow. Although EBITDA won’t show the full picture related to the asset intensity of a business, it does serve as an important measure of operating performance. Buyers commonly rely on EBITDA to form valuations, thus it’s important for sellers to have clean accounting records and a strong understanding of the income and expenses that factor into the business’s reported level of EBITDA.
If you're interested in exploring EBITDA and valuation in more detail, download our small business sale guide.
