Having a reliable measure of your business’s financial health is important to ensure its viability and its resale value. EBITDA (earnings before interest, taxes, depreciation and amortisation) is an accounting technique that offers a standard measure of profitability.
Unlike other net income calculations, which use simple formulas like revenue minus expenses, EBITDA allows analysts to better project a business’s long-term profitability and ability to pay off future financing.
A healthy EBITDA can add value to a business and help the owner achieve a good deal when selling.
To calculate the EBITDA of your business, you need to know its income, expenses, interest, taxes, depreciation (the loss in value of operational assets like equipment over time) and amortisation (expenses for intangible assets like intellectual property over time).
There are two ways to calculate the EBITDA of your business:
- Revenue – expenses (excluding tax, interest, depreciation and amortisation), or
- Net income + interest, taxes, depreciation and amortisation
Problems with Using EBITDA
The only issue with relying on EBITDA as a performance indicator is that it doesn’t take into account changes in working capital. The liquidity of a business (its ability to convert assets into cash to pay debts) fluctuates due to capital expenditure, interest and taxes.
A negative EBITDA can indicate that a business has trouble with profitability, but a positive EBITDA doesn’t necessarily mean the business is financially healthy. This is because interest and taxes are real expenses that the business must account for.
If assets owned by the business are difficult to convert to cash, it can have a low level of liquidity even if it has a high level of profitability. Excluding working capital can result in a distorted valuation.
EBITDA can similarly distort a business’s ability to pay off interest. By adding back losses from depreciation and amortisation, a business’s profit can seem greater than they really are. For these reasons, many people consider EBITDA valuations to be deceptive.
To get an idea of how much operating expenses are cutting into the profits of a business, you can calculate an EBITDA margin. This involves calculating EBITDA and then dividing that number by the business’s total revenue.
EBITDA ÷ Total Revenue = EBITDA Margin
The higher this margin is, the less risky the company is in terms of financial investment. Keep in mind that EBITDA isn’t always the best approach for valuing your business for resale. It leaves out important consideration like history, legal information, market conditions, employees and goodwill.
Getting a Reliable Business Valuation
To get an accurate valuation of your business, you’ll need to provide at least three years of accurate financial information. Valuers may also need to visit the premises to check operations and assets.
Key drivers of business valuation include:
- Financial performance
- Growth potential
- Customer mix and spread
- Cash flow
- Dependency on the owner
An experienced business broker can point you in the right direction. Once you get an initial valuation of your business, you can find ways to improve it so you can get the best possible price when it’s sold.
Talk to a Business Broker with Experience and Expertise
If you’re thinking about selling your business, get in touch with LJ Hooker Business Broking. We are Australia’s leading business broker with extensive experience buying and selling quality small businesses and well-known franchises including Dominos, Kwik Kopy, Dairy Farmers and Michel’s Patisserie.
Call 02 9552 1111 or contact us online to find out more.