EBITDA is an acronym for “earnings before interest, taxes, depreciation and amortization”. It is a measure of a business’s operating performance. Lets start with some of the definitions to get a better understanding:
Interest: this includes company expenses caused by interest rates. This includes interest on loans from banks or third-party lenders.
Taxes: this is any federal income taxes, state, or local taxes imposed in the area by the government.
Depreciation: this is a noncash expense, and the reduction in the value of fixed assets (vehicles, equipment, etc.).
Amortization: this is another noncash expense, and it involves the cost of intangible assets. It’s the process that gradually writes off the initial cost of an asset.
Before we can totally understand EBITDA, its first important to understand what a capital structure is for a business. A capital structure is the specific combination of debt and/or equity used by a business to finance its overall growth and operations. You may have heard how a business could be highly leveraged, meaning that a company uses more debt than equity to finance assets and fund their operation. The alternative is a business underutilizing its growth opportunities by solely funding their business through equity.
Now that we understand what a company’s capital structure means, we can now understand where it comes into play when analyzing EBITDA! EBITDA is a modified view of net profit before accounting for capital structure, taxes, and non-cash expenses like depreciation. EBITDA is part of the equation when determining the value of a business for sale, typically by taking a multiple of it. For example, a lawn maintenance business with recurring services may have an EBITDA multiple of 5x.
It’s important to understand that EBITDA is only one metric and should not be relied on solely to determine the financial health of a business. This is especially true in the green industry, where two businesses could have the same EBITDA but completely different net profit and cash flow levels! For example, lets take a look at two businesses with the same EBIDTA, Company A and Company B. Company A may not use their equipment as efficiently resulting in a 20% higher depreciation expense. Company A may also have all their vehicles financed with high interest payments while Company B was able to fund it through their equity. Which business would you rather invest in? Company B for sure!
When analyzing the financial health of a business you need to take a look into all of the financial statements and KPI’s to give you an overall view into the company’s current state. EBITDA is a great metric to monitor, especially when selling a business, but don’t forget the other financial factors to consider!