As you research how to value your business, have you noticed a couple of acronyms that keep popping up namely EBIT, EBITDA and SDE? When it comes to analyzing a business’ profit and loss statement, we are all familiar with gross income, net income, and net operating income but what are these three acronyms and how can they be used to find out how much your business is worth?
Before we get started, the following description of EBIT, EBITDA, and SDE are based on standard financial statements such as the Profit and Loss Statement and the Balance Sheet for a non-publicly held small and medium-sized enterprises (SMEs) or businesses. Financial statements for large corporations found on the stock exchange are valued slightly differently.
WHAT IS EBIT?
EBIT stands for earnings before (loan) interest and (income) taxes. It measures a business’ ability to generate a profit after paying the operating expenses. It includes annual depreciation but not any loan repayments or interest charges. Thus, EBIT is the same as the net operating income on an income statement.
NET OPERATING INCOME = EBIT
NOTE: By not including any dept repayments, interest expenses, or income taxes, it allows and investor or buyer to gauge the profitability of the business outside of the owner’s financial arrangements or tax breaks.
WHAT IS EBITDA?
EBITDA stands for earnings before (loan) interest, (income) taxes, (annual) depreciation and (intangible asset) amortization. It is similar to EBIT, but it removes the depreciation expense. The amortization expense is not loan payments or mortgage amortization; instead it represents the spreading out of capital expenditures related to items like franchise rights, copyrights or patents. Amortization is not always found on an income statement.
NET OPERATING INCOME + DEPRECIATION = EBITDA
NOTE: EBITDA is a recognized accounting metric used to evaluate a company’s operating performance for businesses earning over $1M. Careful attention needs to be given to make sure that each of the ITDA items are properly removed.
Both EBIT and EBITDA remove expenses that are specific to the business, but not the industry. For example, the owner may borrow against the business which greatly reduces his cash flow; or a buyer may pay cash for the business and eliminate that expense. Either way, the business has the same value. If the mortgage expense was factored into the net profit, the business would have been largely undervalued. Hence, owner-incurred expenses are removed in order to value the business and not the owner’s capital structure.
WHAT IS SDE?
SDE stands for Seller’s Discretionary Earnings. It measures all of the net operating income available to one full-time owner-operator after all business-related expenses are removed. Any owner expenses or benefit payments would need to be added back into the net operating income. An owner’s discretionary items include the owner’s salary, benefits, payroll taxes, health insurance payments, charitable contributions, personal vehicle expenses, and one-time business expenses. Depreciation is also not factored into the net operating income because a new owner will start their own depreciation schedule.
KEY TAKE AWAY: The Net Operating Income found on an Income Statement for a small-to-medium sized business should not include mortgage payments, interest expense, income taxes, owner’s salary, or any owner-specific expenses. As long as this is the case, you can use the Net Operating Income figure to calculate your business value using ratios for EBIT or SDE. If you add back in any depreciation and amortization line items, then you can use that adjusted NOI with EBITDA-based ratios.
How do I Use the EBIT, EBITDA and SDE Figures?
These three different approaches to determining your business profitability are used to convert net profit into the market price for your business. Industry experts analyze the ratios between a business’ sales price and their operating income. Databases are developed and when a large enough dataset is created, those ratios can be used to value businesses within similar categories – such as yours.
For example, as a rule of thumb, full-service restaurants sell for 3 to 4 times the EBITDA, 2.5 to 3.5 times the EBIT and 2.5 to 3 times the SDE plus inventory when the SDE is over $100,000. Using the income statement shown above, the three business income value calculations would create a range of value. This can help determine a list price and possible sales price. Of course, it is subject to finding a ready and willing buyer. But at least you have a place to start.
How Do I Adjust My Financial Statements to Value My Business?
If you are preparing financial statements in order to determine the market value of your business, then you will want to make adjustments which will reflect a true picture of the earning potential of your business. Here are a few steps to follow:
- Remove all non-recurring, one-time receipts or expenses. If you received an insurance settlement check for a claim you made, that income should be removed as it is a one-time receipt. If you paid legal fees to get the settlement, those expenses should be removed since it is not a typical expense the business incurs.
- Remove all non-essential expenses. Other non-essential business expenses should also be removed. The new owner is not obligated to donate to the local football team in order to run a successful business. If a vehicle is not necessary to run the business, but was included more as a tax right-off, it would be a good idea to remove that as well.
- Adjust or remove all owner compensation expenses. You want a buyer to see how much money he or she could reasonably earn each year. If wages, bonuses, and benefits are buried within the expenses, it maybe difficult for them to get a clear picture. If you are using the SDE ratio to calculate business value, then owner compensation expenses need to be removed. If there are several co-owners or partners, their expenses should remain or adjustments should be made to compensate for their contribution to the smooth operation of the business. If you are using the EBIT or EBITDA to calculate business value, then make sure that the owner’s salary is reasonable and reflective of area salaries.
Determining the value of your business can seem overwhelming. You do not need to do this alone, however, your real estate broker, commercial real estate appraiser or CPA would be more than willing to help you calculate the value of your business. Determining a business value by using your business’ income statements is a critical first step in marketing your business.