What is EBITDA and how is it used for business valuation?

What is EBITDA

When researching or discussing mergers and acquisitions (M&A), you may have heard some new acronyms, one of the most common being EBITDA. In this article, we aim to demystify this financial measure and show some background as to why and how it is used to evaluate business performance.

EBITDA Stands for Earnings Before Interest, Taxes, Depreciation, and Amortization

EBITDA means “Earnings before Interest, Taxes, Depreciation and Amortization” and is a commonly used approximation of a company’s cash flow. It is a measure of a company’s financial and operating performance that removes the effects of financing, taxes, and accounting decisions.

How is EBITDA used and how is it calculated?

EBITDA is calculated by adding interest expense, income tax expense, and depreciation and amortization expense to net profit.

EBITDA = Net Income + Interest + Taxes + Depreciation & Amortization

EBITDA is regularly used to value a business for sale, and assess the overall financial health of a company. A company’s value is often expressed as a multiple of EBITDA. When valuing a company, investors and potential buyers will often look at the company’s EBITDA to determine its value. This can be especially helpful when comparing companies in the same industry because it eliminates the effects of financing and taxes on profitability.

A company’s valuation is influenced by EBITDA in two ways, namely: EBITDA margin and total EBITDA.

What is EBITDA Margin and how is it calculated?

EBITDA Margin is calculated by dividing EBITDA by the total revenue.

EBITDA Margin = EBITDA (Net Income + Interest + Taxes + Depreciation & Amortization) / Revenue

EBITDA margin (EBITDA divided by revenue) has a “sweet spot” of 10% – 20%. Below this range may be indicative of operational challenges. Above this range may suggest some unsustainable business practices.

What does EBITDA reveal about your business?

Since EBITDA excludes non-cash items such as depreciation and amortization, it can provide a better insight into a company’s true profitability and cash flow.

A higher total EBITDA typically results in a higher business valuation. This indicates that the company is generating more cash flow and is more likely to be able to pay off its debt and generate higher returns for investors.

EBITDA & EBITDA Margin Examples

Let’s say a home services company generates $20 million in revenue and incurs $12 million in cost of goods sold and another $5 million in overhead. Depreciation and amortization expenses total $2 million, yielding an operating profit of $1 million. Interest expense is $500 thousand, leaving earnings before taxes of $500 thousand. Net income equals $300 thousand after $200 thousand in taxes is subtracted from pretax income. If depreciation, amortization, interest, and taxes are added back to net income, EBITDA equals $3 million.

Using the same example, you can calculate the EBITDA Margin by taking the $3 million of EBITDA and dividing it by total revenue of $20 million = 15%

What is a good EBITDA for a home services company?

The answer to this question depends on the size and the financial performance of the HVAC and/or plumbing company. Generally, a healthy EBITDA for a mid-size home services company is between 10% and 15% of their total revenue. This means that the company is generating more in revenue than it is spending on costs and expenses. If an HVAC and plumbing company is earning an EBITDA of at least 10% of its total revenue, that would typically be considered good performance.

Ideally, Friendly Group partners are experiencing profit margins between 10% and 20%. If your EBITDA is in the high teens, you’re doing a lot of things right.

Numbers in the high 20’s are great, but this level of profitability is usually not sustainable in the long run. There are also some great companies with an EBITDA in the single digits that may just need some fine-tuning.

What Friendly Group Looks for in Partner Companies

It is not just about a company’s financial performance—Friendly Group employs a holistic approach to qualifying potential partners.

While EBITDA is an important measurement used during business valuation, Friendly Group emphasises the value of established brands with solid reputations that employees want to work for.

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