Why is EBITDA so popular ???

Author: Joris Kersten MSc

Kersten Corporate Finance:

Joris Kersten (1980) buys and sells companies in The Netherlands with an enterprise value of in between 2 million and 100 million euro (SME market + mid market). Moreover he conducts lots of Business Valuations for all kinds of settings.

Article: Why is EBITDA so popular ???

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Earnings before interest tax depreciation and amortisation (EBITDA) is used all over the globe for business valuation with for example M&As (Mergers & Acquisitions).

But why is EBITDA so popular ?

When we look at the profit & loss statement (P&L) of a company it all starts with revenue.

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Revenue

Revenue is P * Q (price times quantity) of for example a product that you sell.

But we all know that there are costs involved: COGS (costs of goods sold) and OPEX (operating expenses).

And revenue minus COGS is the gross margin.

First, something funny happens with revenue, because so called “revenue recognition” applies.

This basically means that you can speak of revenue under certain circumstances, for example when you are sure the product is sold (even when the money is not paid yet).

So it is very important that you know for every company that you analyse when, and how, revenue is recognised.

This since this number comes up in the P&L (again, even when the money is not paid yet).

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COGS

With product sales, at the moment when revenue is recognised, also the COGS need to be matched with the revenue recognised.

So when you can legally recognise the sales of 10 products (even when the money is not yet paid by the customer), you need to match the “buy in price” for the 10 products as well in the COGS (even when they are not paid yet to the supplier).

And what is left is called the gross margin !

And by the way, this matching of costs is called the “matching principle”.

So be careful, it is possible that money is not yet paid by the customers, and it is possible that the company has not paid their suppliers either.

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Gross margin

Another thing with gross margin is that depending on how cost price is set (variable costing or absorption costing), more or less costs can be taken up in the COGS, which will result in hard to compare gross margins of different companies.

Some take up additional costs in the COGS, and other companies take them in the SG&A (sales, general and administrative expenses).

So revenue misses the important involved costs (COGS + OPEX), and gross margins are difficult to compare because cost prices are calculated differently.

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SG&A

Out of the SG&A we need to clean D&A (depreciation and amortisation).

Depreciation is writing down tangible assets and amortisation is writing down intangible assets.

We call these costs, but no cash outs, so we want to neglect them (for now), because D&A is a bookkeeping concept.

Gross profit minus ( SG&A -/- D&A ) = EBITDA.

At EBITDA basically the most important costs are taken in the form of COGS and OPEX (SG&A).

So EBITDA seen as a percentage of revenue really tells something about the operating efficiency of a company !

Again, be careful, the matching principle also applies for SG&A, so some costs are matched in the P&L (so also in EBITDA), but they might not be paid yet !

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EBIT

We can still go further down to EBIT, and here we take the D&A from EBITDA.

But the problem with D&A is that it is still subjective, because it is set by the board (although signed off by the auditors).

And on top of that D&A is a cost but not a cash out (is has a little effect on corporate tax do).

So basically at EBIT we are down one step too far.

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EBT

EBIT minus interest is EBT (earning before tax), but here interest comes into play.

And we do not like interest !

Because interest has to do with capital structure, and capital structure is a decision of the board, and it has not much to do with the operations.

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Net income

Here it becomes even worse, because here also tax has been deducted.

But the amount of tax paid is also a decision of the board.

Companies have an “effective tax rate” (ETR) depending on how much tax optimalisation they are tolerating, again this has not much to do with operations.

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EBITDA

So maybe you now start to understand that EBITDA is the "least bad" line in the P&L.

I consciously say "least bad", because EBITDA says nothing on:

-When customers pay, and when suppliers and stakeholders get paid (net working capital);

-How, and when, capital expenditures (CAPEX) are done;

-With how many assets this EBITDA is made;

-A normal level of corporate tax, and interest, that always needs to be paid.

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This is why I will tell you a little more on FCF (free cash flow) in my next article !

In the meanwhile, find my free book (300 pages with PRACTICAL articles) on M&A and valuation here on LinkedIn !

And feel free to contact me for M&A advisory (sell side + buy side) and valuations in The Netherlands.

Best regards, Joris Kersten

Kersten Corporate Finance