Smith Holland M&A Resources
EBITDA isn't always the same as cash flow, especially when debt involved.
As examined in other articles, EBITDA (Earnings Before Interest, Depreciation, and Amortization) remains an essential lever in assessing and benchmarking a business valuation when preparing to sell your business. A vital tool in leveraged buyouts, EBITDA can help provide guidance on the debt load a company can carry. A company that has been in operation for years, with minimal tangible assets and outstanding debt would benefit from a valuation based solely on EBITDA. That business would not show a substantial difference in operating cash flow or bottom line net income, and a buyer could feel confident on an initial assessment on EBITDA as the primary motivator. Wouldn’t a one-stop solution to each and every business scenario be nice? The financial decisions of every enterprise are unique, so too should be the metric one is valuing a prospective acquisition.
Not to be considered an end-all solution, EBITDA calculations do not take into consideration certain factors when outputting a valuation. This creates deltas in the perceived price of the business, as buyers attempt to reveal the nuances that make a straight EBITDA valuation veer from what is presented in a prospectus or offering memorandum.
There are three line-item expenses that have a tendency to fall out of the EBITDA calculation and ultimately create disparity in valuation. They are as follows:
Depreciation. If a business decides to aggregate depreciation into the EBITDA calculation, but not CAPEX - calculated as investments in plants and equipment - it creates a bubble in cash flows. On the contrary, a business that withholds depreciation from the EBITDA calculation will have lower-than-expected cash flows. This holds especially true in cases of accelerated depreciation, where the EBITDA would take a massive hit, but the actual cash flows would remain strong as the depreciation is an accounting figure.
Adjustments to Working Capital. The EBITDA-based valuation method does not factor in fluctuations to working capital. The assumes a company receives payment in advance of the actual sale of goods. In reality, most businesses enact a service or sell a good, then they bill the customer, many times long after the actual transaction date.
Capital Expenditures. The shipping, telecom, aviation and even the oil and gas industries all need a large capital investment in machinery and equipment to maintain operations. However, CAPEX does not factor into the EBITDA formula. Thus a company may appear to have substantial EBITDA, but minimal cash flows after CAPEX payments are taken into calculation.
EBITDA RELIANCE PITFALLS
By extracting those line items, the business will show cash flows that are higher than reality. A savvy buyer will bring these items to the table as part of negotiating the valuation, as should the middle market mergers and acquisitions firm representing the company. The ultimate factor is the future of the company: does the new owner have the cash on hand to pay for the loan and CAPEX decisions of the previous owner, or is the future of the transaction at risk?
The common method of adjustment EBITDA, or allowing add-backs, means to increase the paper value of the company. A buyer can create his or her valuation by removing these add-backs and considering the true cost it would require to maintain operations, let alone grow the business! It is important for the M&A team to have answers to why every add-back has been adjusted.
To put the situation into a real-world example, consider the following: a pizza shop opens in a renovated shopping district. The owner has to gut the entire space, and start from scratch with brand new plumbing, electrical, ovens, fixtures, appliances, seating, etcetera. Most of those items can be considered capital expenditures in the accounting books. This also means most of these expenses are considered one-time, or up-front costs needed to start a business - if the business goes on the market, the prospective buyer won’t need to have the space fitted for electrical wiring or to install new floors...hopefully. At the end of the year, the company does great, with $1,000,000 in sales. After all the employees are paid and normal lease expenses are taken care of, the EBITDA calculation begins to take shape, around $200,000. Another year goes by, the same story, but a little growth. In year three, an outside circumstance forces the owner to have to sell the pizza shop. An M&A team is brought in to provide an analysis and valuation for the impending sale. Before the final verdict, a tough decision must be made. EBITDA, as mentioned, looked strong at around. Cash flows, on the other hand, were nowhere in the proverbial ballpark. With the massive capital expenditures required to start the business, the actual interest, depreciation, and amortization consumed most of the company’s hard-earned cash. The M&A team should decide the pizza shop’s valuation on more than EBITDA alone. By considering cash flows as well, a seller can feel assured the true market valuation is being attained. An informed buyer is what every transaction wants because it builds confidence in reaching a closing by reducing the risk of surprise details in late stages. There comes an inherent time risk involved with all transactions. No matter how good of a fit the company is for a new buyer, or how attractive the financials and future sales look, both parties can reach fatigue or amount of sunk costs that are too much to burden. Transparency of company documents and particularly financials is an essential mindset to hold during a sale, it eliminates any perception of information-withholding or any other unethical behavior. Buyers are connected, do not let a negative connotation sour a deal or even go as far as to leave a stain on the company to affect the value or saleability.
All these warnings considered, EBITDA remains a surefire tool to analyze two companies competing in similar industries or sizes. Two roofing companies operating in comparable market sizes, with a similar crew size and product offerings might best be surface by an EBITDA comparison early on. Typically, there won’t be massive hidden capital expenditures or working capital line items that would make an early assessment seem a waste of time.
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