EBITDA Margin is the number that compares apples to apples in terms of earning potential and leverage ability of a business.
One acronym that is all the rage nowadays in the small business world is “EBITDA.” It’s really only been popularized in the last few years, so if you’ve never heard of it, don’t beat yourself up! The term was initially coined in the 1970s by John C. Malone, American billionaire and then CEO of Tele-Communications Inc., a massive media conglomerate. At the time, Tele-Communications Inc. was expanding its business mainly through the leveraged acquisition of other media companies; EBITDA was their chosen metric for evaluating which of those companies would be able to support the debt service required.
That’s cool! But, umm, what does it mean?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. Despite its widespread popularity in the public conversation surrounding business, specifically business acquisitions, it is a calculation not excepted in creating official financial statements by IFRS (International Financial Reporting Standards) or GAAP (Generally Accepted Accounting Principles) for our American friends.
To understand how to calculate EBITDA in a company, you must understand the key figures that can be taken from its financial statements. On the Income statement or Statement of Profit or Loss, you will want to look for a line titled Net Income, sometimes referred to as net profit or the bottom line because it’s quite literally the bottom line on the income statement. The other four lines you will need to find on this statement are, from bottom to top, Taxes, Interest expenses, Depreciation and amortization; the last two are sometimes on the same line. Once you have found all these values, the calculation is simple:
EBITDA = Net Income + Taxes + Interest Expenses + Depreciation + Amortization
Now that we know what EBITDA is and how to calculate it, only one question remains…
Is it a valuable metric in evaluating a business?
Like most things in business, the answer depends on what you want to find out! If your goal is to determine if the business cashflows enough annually to service the debt that may need to be incurred for its acquisition, then it's a good figure to use for that purpose. You’ll still need to remember that if the business you are analyzing is recording depreciation on its balance sheet, there are likely physical assets with actual costs that will need to be purchased sometime in the future for this business to continue operating. If you use leverage to make the acquisition, it would be wise to figure out the timeline and do your borrowing calculations based on a payback period that fits inside that timeline and still offers a generous net profit margin. Suppose there is Amortization on the income statement. In that case, it is best to ask some questions about what intangible assets it is being claimed on and, once they are amortized fully, how does that affect the business's unique value proposition?
Long story short, EBITDA is a valuable measure of a company's earning potential. Still, you need to understand what it tells you about the business and its value to use it to its full potential!
How can EBITDA be used to compare the viability of different businesses you are considering acquiring?
There needs to be more than just knowing the EBITDA of each business on its own to make a final decision to purchase. If Company “A” has an EBITDA of $1,000,000 and Company “B” is only at $500,000, then the choice is relatively straightforward, supposing they both earn a gross revenue of $2,000,000 annually. However, if Company “A” has a gross revenue of $10,000,000 and Company “B” has a gross revenue of only $2,000,000, your money would go a lot further purchasing company “B”. Let's break down why that is and some other essential factors to consider.
With an EBITDA of one million dollars and gross revenue of 10 million, Company “A” has an EBITDA Margin of 10%, whereas Company “B” bolsters an EBITDA Margin of 25% in this scenario. EBITDA Margin is the number that compares apples to apples in terms of earning potential and leverage ability of a business.
With all this in mind, I recommend you do a deep dive into the depreciation and amortization cost currently and historically affecting the bottom line, even if the EBITDA margin looks promising. Let’s say Company “A” has had no depreciation or amortization on the books for the last 5 years because it is a service-based business with no notable assets required for daily operations, like an internet SEO business that leverages virtual assistants with their own devices on contract. In this case, most of the delta between gross revenues and EBITDA is likely paid out in labour cost and likely very stable, predictable income. Company “B”, however, has $400,000 per year in depreciation on the books over the past 4 years for hard assets that are paid for but will need to be replaced in the near future. The replacement cost of the assets currently being depreciated will be $2,000,000 and only last 5 years once purchased, so the EBIT margin, in this case, would only be %5. This is obviously considerably less money going into your pocket each year if you’re leveraging the assets or much more down if you’re paying to replace them upfront a year after purchasing the business.
The point we are getting to here is that analyzing the viability of a business you are looking at purchasing, or starting for that matter, is not a case of just finding one all-knowing figure and saying, “The higher the EBITDA, the better the business!” Many factors need to be considered, and you should consider talking to your accountant for a complete understanding of each business's financials before moving ahead with an acquisition! If you want to know more about how we can help put together some projections for your business plan to help assess the business's viability, make sure to book a free consultation on the home page!
.jpg)
