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What Is EBITDA and Why is it Important?

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“EBITDA” is an acronym meaning Earnings Before Interested Taxes Depreciation and Amortization.  It is the most important metric used in the appraisal of middle market businesses, those with an estimated value of $1-100 million or with EBITDA exceeding $350,000 - $500,000.  It is an estimate of the total financial benefit an investor or absentee owner would derive from the business on an annual basis.

A business’s overall EBITDA is generally calculated as an average of the EBITDA for the 3-5 most recent years. If there is a strong trend in the earnings (up or down), much more weight tends to be placed on more recent years.  EBITDA is calculated for each year based on information from the business tax returns, the profit and loss statements (P&Ls), other financial records and owner estimates. 

Calculation
There are two common approaches to calculating EBITDA.  One is to calculate Seller’s Discretionary Earnings (SDE), then subtract from SDE the expected total annual compensation and benefits for a general manager capable of running the business.  The absentee owner, in effect, receives the SDE less what s/he has to pay the general manager.

Alternatively, EBITDA can be calculated for each year without reference to SDE as follows:

• Pretax net income, plus
• Interest expense (because business debt is a “non operating expense” and assumed to be paid off),  plus
• Depreciation and amortization (non cash expenses), plus
• “Discretionary expenses” or perks that meet four criteria.  They: 1) benefit the current owner, and 2) are paid for by the business, and 3) are reported on the tax returns and P&Ls, and 4) do not benefit the business.  Common examples include:
• Health and/or life insurance for one owner/ owner’s family
• Personal use of automobiles
• Personal travel, meals and entertainment
• Personal use/consumption of products/ services
• Any other personal expense
• Family members on the payroll but not really working in the business, or the portion of their earnings that are above market wage
• Plus

Adjustments for extraordinary, non recurring expenses or revenue (e.g., expenses from a rare lawsuit or flood damage would be added back; revenue and expenses from a major discontinued product would be removed)