Why Focus on EBITDA? Seven Good Things for Businesses and Business Owners

Today’s valuation video addresses EBITDA, not as a number, but on a conceptual basis. We discuss seven good things that flow from EBTIDA that make it a focal point of analysis for bankers, investment bankers, private equity participants, business owners, and business appraisers. A clean version of the whiteboard is available for downloading in the blog post.

Why–why do business owners, business appraisers, investment bankers, bankers, private equity folks, and all market participants–why do we focus (sometimes obsess) on this thing called EBITDA?

I’m Chris Mercer and today’s valuation video is titled “Why focus on EBITDA?”

It is the beginning point of all good things that happened to businesses and business owners.

I talk about EBITDA not as a number because EBITDA is really the result, its result of sales. We have to be in business to have EBITDA, so we generate sales and then we have expenses. We don’t have a business unless we’re in business selling and operating and so forth, but all expenses excluding depreciation and amortization. And what do we have left? We have EBITDA.

Now, I’m not talking about just a number, EBITDA. I’m not one of those guys that focuses on six times some magic number because EBITDA comes with a context. EBITDA comes with a dollar level for a particular company. It is the level of EBITDA the dollars at a particular point in time. It comes with a margin and margin is important in terms of riskiness. It comes with growth and then it comes with its own inherent risk. If the EBITDA comes from one customer instead of a diversified portfolio of customers, that’s quite another thing.

So, we begin with EBITDA and this conceptual thing on EBITDA is just a number. It’s a conceptual thing. I said all good things come for businesses and business owners from EBITDA. Let me go through and show you the seven things that come from EBITDA.

Number one. We can pay interest on debt for our companies and that’s important. Number two. We can pay taxes. We all have to pay our taxes and it’s good to have the cash flow to pay taxes and that leaves us with something I would call net operating cash flow. That’s an important number too, but it starts with EBITDA. With net operating cash flow, we can repay principal on debt and bankers like that when we do it on time. We can invest in working capital if we’re growing. And we can replace our capital investments, replacement capital expenditures. We have to do that to stay in business. And then we can invest in growth. Capital expenditures for growth. We spend all of those monies it all comes from EBITDA and if anything’s left, it’s owner distributions and share repurchases. So that’s coming from EBITDA.

So those are seven things. I said all good things for businesses and business owners. Let’s look at it.

It’s good to pay interest. It’s good to pay taxes. It’s certainly good for the bankers if we repay it. It’s good to invest in working capital if we have opportunities. It’s good to replace our capital expenditures when necessary. And it’s good to invest in growth if we have those opportunities. And to the extent that we have not consumed all cash flow at that point, it’s good to make distributions to owners because those distributions to owners are the current returns to owners and those are good things for business owners.

All of these things, the repayment of debt through growth capital expenditures, contribute to the capital appreciation of a particular business. So capital appreciation, of course, though is a function not only the operation of the business, but the operation of markets as well. Current returns plus capital appreciation is the total return to the owners of a business. That total returns to the owners of a business can be in dollars or as a percent of the market value of equity. So we need to know something about valuation as well.

Why do we focus on EBITDA for bankers, investment bankers, private equity folks, business owners, and business appraisers? Because it is very important. It is the source of all good things that come to businesses and business owners.

If you’d like to talk about EBITDA, if you’d like to have a question about valuation, feel free to call me and if you’re reading this on the blog post or on LinkedIn, feel free to make a comment down below.

I look forward to hearing from you. Good day.