#EBITDA article series
Evaluating a startup is an extremely taxing procedure. Among all the dynamic solutions available for quality startup valuation, EBITDA and DCF are two accounting methods used by companies. Between the two, the former is a useful formula to measure the long-term growth potential of startups. Investors use the result to influence their decision to invest in a particular startup and compare different businesses. These metrics deliver on mapping the financial health of an organization.
Additionally, in the corporate world, EBITDA is a popular calculation metric to measure a company’s profitability. It gives a reasonable estimation of actual profit trends. It does not consider the extraneous factors to provide accurate results that are used to compare different companies. Furthermore, the metric is also used as a shortcut valuation method to find out the cash flow available required to pay off the debts of long-term assets. So, industry averages can easily be measured through the method.
Understanding EBITDA
Earnings Before Interest, Taxes, Depreciation and Amortization, or EBITDA measures your business’ scale. By using this metric, you can have an estimation of the financial status of your company.
What is EBITDA?
Besides startup valuation, it is also used as an alternative for calculating net financial income. Even though it is a fairly common procedure to measure a startup’s valuation, it is not absolute. It does not take into account expenses of other investments like equipment, plant, property, etc.
Along with the above, the metric does not include debts by the company because the method adds up interests and taxes to the earnings. Because of this, the calculation metric could be misused to produce company earnings higher than the actual figure.
However, even after deducting debts from the calculation metric, the metric is a precise calculation method for corporate financial reports as it can show earnings before accounting and financial deduction’s influences. Also, the metric helps business owners understand the extent of profitability and the growth opportunities of their businesses.
What is a good EBITDA?
A good EBITDA helps sense a company’s financial prowess. Naturally, a higher value signals better financial health of a company than relatively lower values. However, various companies and industries of variable sizes in different sectors have different values. The valuation of a startup is dependent on the kind of services it provides and its size. Therefore, a good practice would be to find companies in the same industry and sector and of the same size to evaluate the strength of a startup’s Earnings Before Interest, Taxes, Depreciation, and Amortization metric.
Importance of using EBITDA
The metric is popularly used to find out a company’s cash flow. For an analyst, the calculation method provides a quick understanding of a company’s value. It also gives a valuation range to an analyst by multiplying the company value by a valuation multiple evaluated from equity research reports, M&A, or industry transactions.
Besides being a helpful metric to financial analysts, companies turn to EBITDA to understand their economic progress with respect to their competitors. It is an excellent indicator of the financial status of a company in a familiar business sector.
Also, the tool helps business owners make the right policy or business changes when they are not running in profits. Aside from being an excellent comparison tool, the metric works as an indicator to show business owners and associates the performance probability of the company in the short and long term.
Limitations of EBITDA
Even though there is no legal compulsion to disclose a company’s Earnings Before Interest, Taxes, Depreciation, and Amortization values, the method is not accepted by GAAP (Generally Accepted Accounting Principles), a standard financial performance measure. The metric does not qualify for GAAP as its evaluation is not consistent between companies.
It is not uncommon that companies prefer EBITDA over their net income because it is more flexible than other metric systems. Also, the measurement method can be quite distracting as it does not emphasize other problematic areas in a company’s financial statements.
Ignores costs of assets
The metric does not represent the cash earnings of a company. Also, it does not see the asset costs, like that of free cash flow. Calling it a true representation of the cash earnings of a company will be inaccurate.
Another common criticism that the metric faces is that the metric understands profitability to depend on sales and operations only. A company is survived by assets and finance too. But the metric does not take company profits to be a function of financing and investments.
Ignores working capital
Among all the parameters that the metric leaves for calculating profitability, one is the crucial element of the money required for funding working capital. Another element is the expense related to old equipment replacement. The profit calculation is only concentrated on sales and operational costs.
For instance, even though a company sells its product for a sizable profit, the question remains which resources are utilized to acquire the inventory required to charge its sales channels? Furthermore, the metric ignores the costs related to developing the latest software versions or future products in the software industry.
Varying starting points
Various companies use varying earning figures as the starting point for calculating EBITDA. Because of this, the calculation metric opens the scope of tricking the company account calculations on the income statement. For example, while deducting tax charges, interest payments, depreciation, and amortization from earnings may appear to be a simple process.
Still, different companies produce different figures by starting from varying starting points. Even if the discrepancies from interest, depreciation, taxation, and amortization in EBITDA are considered, it still fails to produce reliable earning figures for a company.
Obscures company valuation
The metric may make a company look less valuable than it is in reality. This may happen when analysts look at its stock price multiples rather than the company’s bottom-line earnings. The stock price multiples of the metric result in lower multiples.
How to calculate EBITDA?
A company’s EBITDA can be calculated from the information gathered from its cash flow statement, income statement, and balance sheet. The calculation formula is –
Earnings Before Interest, Taxes, Depreciation, and Amortization = Interest + Company Taxes + Depreciation + Amortization + Net Income
OR
Earnings Before Interest, Taxes, Depreciation, and Amortization = Depreciation + Amortization + Operating Profit of a company.
Components of EBITDA
Precise results can be produced when each component of the calculation formula is understood thoroughly.
Earnings
Earnings are company turnovers over a specific period. Earnings can be calculated by subtracting the operating costs from the total company revenue.
Interest
The cost of servicing debt is a company’s interest expense. Apart from this, it is also the interest earned by the company. However, in most cases, interest points towards a company’s expense. In the calculation formula, interest-related costs are not subtracted from the company earnings.
Taxes
The calculation metric measures company earnings before calculating its taxes. Operating profit, often referred to as EBIT, is a company’s earnings before interest, taxes calculation.
Depreciation and Amortization in EBITDA
The general meaning of the term ‘depreciation’ is the loss in value of tangible company assets, generally related to their usage over a while. Such depreciated assets include company machinery, vehicles, etc.
On the other hand, amortization in EBITDA deals with the expiration of intangible company assets, such as patents. In the calculation, depreciation and amortization are added to the operating profit or EBIT to get the final value.
Example of calculation of EBITDA for startup valuation
To understand its calculation better, Professor Ron Auerbach of the City University of Seattle came up with the following example:
Say Company X has the following financial credentials:
· Company net income = $1,800,000
· Interest paid = $ 260,000
· Depreciation amount = $ 180,300
· Amortization = 0
· Taxes = $ 132,500
So, according to the formula listed above, the EBITDA calculation of company X would be:
= Net income + Interest paid + Depreciation amount + Amortization + Taxes
= $ (1,800,000 + 260,000 + 180,300 + 0 + 132,500)
So, EBITDA = $ 2,372,800.
How does the EBITDA method help in startup valuation?
Evaluating the worth of a startup is not a simple process. Company figures are vital as it helps to get funds from investors. Also, a startup valuation is used to understand financial health with respect to industry standards. In such cases, a strong solution has to be used to find the most relevant results in startup valuation.
EBITDA is one such effective method to measure a company’s cash flow generated by its activities. It is one of the two reliable methods of measuring a company’s growth and performance, the other being Discounted Cash Flow (DCF). A positive value is an indicator of a company’s profitability.
In other words, a positive value means that the company sells its products or services for a price greater than the production cost. Conversely, a negative value implies that the company is procuring losses from its products or services.
Therefore, through the metric, companies can have a clear picture of their business situation. Since investors look for an accurate metric to measure the viability of an investment, EBITDA works to give the investors ample idea to understand the map of the particular company’s development.
Conclusion
EBITDA provides a fair analysis of a company’s finance. In order to provide ample proof of the company’s value, the metric has to be applied and calculated efficiently. However, relying too heavily on the startup valuation may not be favorable while selling off a company. The estimated value does not influence the selling price of a company alone. A company’s intangible assets, performance, consumer base, know-how, and growth potential are also crucial indicators for its saleability.
