New business owners looking for investors and those who have been in business for years often use EBITDA to gain investors. What is EBITDA, and is it an accurate forecast for investors? Jean Scheid explains what EBITDA reveals and what it hides.
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EBITDA is an acronym for “earnings before interest, taxes, depreciation, and amortization." In most cases, when an investor is looking at companies to invest money into, they want to see earnings or sales revenues without all the deductions—or a company’s performance.
Because deductions such as interest, taxes, depreciation, and amortization do make profits lower, you may be wondering, why even use EBITDA as an investment tool?
When considering, what is EBITDA, an investor may choose this type of report to explore a company’s sales revenues or determine how well a company’s sales are doing based on sales forecasting.
Expenses are inevitable, and investors realize this. What they do like to know is if a company is indeed able to sell their products or services and at what level.
Take a look at any balance sheet and you will see a net profit, but net profits are determined after all expenses including the elements of EBITDA. The downfall of using an EBITDA report as an investment tool is that it may not show issues a company may have such as:
Interest – Here, interest paid out can be a substantial amount or very low depending upon capital loans or other types of leased equipment or purchases that come with interest and principal payments. If an investor doesn’t explore interest on capital loans prior to making that initial investment, they may find out later that a company has excessive loans and high interest payments each month.
Taxes – Unless a company is a C Corp, an entity that is taxed at the corporate level, taxes on gains really don’t come into play in an EBITDA report. Entities such as LLCs or S-Corps are pass-through entities where the company pays no tax (although shareholders do). Investors do need to ask when considering what is EBITDA, if the company has any outstanding sales taxes or other taxes. These “other" taxes are not shown in an EBITDA format, meaning a company could be behind on taxes, such as 941 employee taxes with the IRS—something no investor wants to deal with.
Depreciation – Sure that EBITDA report may show a company’s fixed assets or inventory at high levels, but without the depreciation expense included, how can investors determine the true value of fixed assets?
Amortization – Again, if a company has capital loans, using EBITDA to determine just sales revenues skips the all-important monthly loan payment(s). Investing money into a company with high sales revenues only to find out those sales revenues won’t cover those monthly loan payments can be difficult once you’re an investor or partner.
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Why Bother With EBITDA?
There are many reasons why using EBITDA to determine a company’s value is a good idea, especially when it comes to analyzing competition of like businesses or franchises in a certain area. For example, a person who asks what is EBITDA, understands the method, and uses it, will be able to see if one bookstore is outselling another in the same vicinity.
Surely a franchised fast-food restaurant that outsells its closest competitor 2:1 looks juicy to that investor who has cash to invest.
Often, although silly as it sounds, investors looking for tax breaks (losses) to avoid high tax payments to the IRS, will use EBITDA reports to find companies that have low revenues and high losses.
Banks and franchisors also use EBITDA to determine if funded or franchised companies are performing at set levels, or forecasted levels.
In the long run, however, unless you are an experienced investor, it’s best to skip the question what is EBITDA, and ask for reports such as a true cash flow pro forma or income statement to best determine how well a company is doing before taking the risk to invest.