Tuesday, 30 October 2012

The Truth About EBITDA vs. Cash Flow

EBITDA and Cash Flow are essentially the same measurement, with a couple of exceptions – usually BIG ones. 

EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) leaves in, or adds in if necessary, an expense for a General Manager to run the operation and does not recognize Discretionary Expenses as being discretionary.

This is why a “multiple” used in an EBITDA evaluation is usually higher than one used in a Cash Flow evaluation.  The reason being is with the EBITDA measurement, because there is “management in place”, the buyer is buying a “passive” investment.  Hence, the Buyer is generally prepared to pay a higher multiple (and earn a smaller return on their investment).

The following example of the same Business highlights the point:

Net Profit $800,000 $800,000
Adjustment for GM at FMV (fair market value) -$150,000 not applicable
Adjustment for Discretionary Expenses not applicable $110,000
Adjusted Net Profit $650,000 $910,000
Multiple x4.14 x2.93
Value of Business $2,691,000 $2,666,300

Due to the reasons outlined earlier, an EBITDA Buyer may pay a higher “multiple” for the business, but the business has essentially the same value.

This subtle but significant difference between “multiple” in these two methods can mean a big difference if the wrong “multiple” is applied to the wrong measurement.  For example, an EBITDA multiple of 4.14 applied to a Cash Flow Adjusted Net Profit measurement of $910,000 will grossly overstate the value of the business.

Typically you will find the majority of businesses in “Main Street” transactions generally have an Adjusted Net Profit of $600,000 or less, and typically have the owner as the operator of the business reaping the benefits of the Discretionary Expenses.

Do you have a small business question you would like answered about this article or others?
Bill Sivell is a salesperson with VR Windsor Inc. [www.vrwindsor.com] 519-903-7807, which sells businesses to buyers across Canada and around the world. His 14-year career includes diverse senior management positions in marketing, advertising, sales management and operations management. His blog appears every Tuesday.


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