Figuring out the value of a company can be complex.
It requires looking at how the business is performing today — and figuring out how it might grow and what kind of profit it might yield for future owners.
To tackle this challenge, investors and accountants over the years have used formulas that present an accurate picture of a company’s potential. The most important for businesses looking to sell is EBITDA.
How to calculate EBITDA
Want to know your company’s potential for earnings or figure out its valuation based on EBITDA?
Start with this EBITDA formula:
EBITDA = Net income (Earnings) + Interest + Taxes + Depreciation + Amortization
Now, what does that actually mean? We’ll help you understand it.
What is EBITDA?
EBITDA stands for “earnings before interest, taxes, depreciation and amortization.”
This formula is one way to measure a company’s financial performance, and it’s the number often used to determine a company’s value when the focus is earning potential rather than current profit.
EBITDA also shows what it truly costs to operate your business, which is particularly helpful for a potential buyer.
Let’s break down the acronym.
- Earnings before: EBITDA starts with your earnings, a.k.a. net income, with the below non-operational costs that might otherwise affect the earnings number added back in. So, it’s “earnings before” those costs are subtracted.
- Interest: Cost of interest you’re paying on the company’s debt, like loans, credit cards or venture debt.
- Taxes: The company’s corporate income taxes.
- Depreciation: The cost of the company’s physical assets divided by the useful life of the asset. (This is a way to spread the cost over an asset’s lifetime.)
- Amortization: The scheduled fees on loans divided by the loan term, a way to spread the cost of fees over the life of the loan.
Why is EBITDA important when you’re selling your business?
Why would you value your business based on earnings that doesn’t account for all expenses?
Owners use EBITDA to determine valuation when selling a startup because it offers a more accurate picture of a company’s potential for profitability.
“The reason why buyers use EBITDA is because it represents the true earnings power of a business,” explains David Tolson, founder and managing director at Class VI Partners. “It is independent of structural elements such as how much debt a company has.”
Buyers and investors may value startups based on multiples of EBITDA rather than revenue, which is used in many cases for more mature businesses.
Rapidly growing startups tend to have quickly increasing revenue, but they put most of their cash (what would otherwise be profit) back into the business — they reinvest it — to scale faster. Looking strictly at net income at this point in a startup’s growth would show skewed results because of the costs of debt, even for businesses with incredible potential to make owners money at scale. Because of this, it’s not uncommon for startups to have a negative EBITDA.
Note that EBITDA doesn’t ignore all of your expenses. It just adds back non-operational expenses. So you’re still accounting for the costs to deliver your goods or services, like worker wages and cost of goods sold (COGS). But EBITDA balances out the strain of funding rapid growth.
We’re reporters, not accountants. If you need help with financial decisions, please hire a financial professional. The information contained in this piece is provided for informational purposes only, and should not be construed as financial advice.