Calculating EBITDA
man in suit using calculator

“My business is my pension” 

Many business owners view their business as their pension without knowing its true value and how to realise this dream.

One metric that can help you assess your business’s financial health and maximise the value of your business is EBITDA (or EBIT in certain industries). In this article, we will explore what is EBITDA, how to calculate it and how to use Adjusted EBITDA to understand and drive the true value of your business.

What is EBITDA?

EBITDA is an acronym that stands for Earnings Before Interest, Taxes, Depreciation, and Amortisation. It is a financial metric used to evaluate a company’s operating performance and profitability. EBITDA provides a clearer picture of a business’s financial standing by excluding subjective factors such as interest expenses, taxes, and non-cash charges like depreciation and amortization.

Understanding the Components of EBITDA

To grasp the concept of EBITDA, it is essential to understand each component of the acronym:

Earnings – Earnings refer to a company’s net income or profits. It represents the revenue generated by the business after deducting all expenses, including the cost of goods sold, operating expenses, and taxes.

Interest – Interest is the expense paid by a company against any capital borrowed. It includes interest on loans, lines of credit, and other forms of debt financing.

Taxes – Taxes represent the amount a company pays in taxes, such as corporation tax.

Depreciation – Depreciation reflects the decline in value of a company’s tangible assets over their useful life. It is an accounting method used to allocate the cost of an asset over its estimated lifespan.

Amortisation – Amortisation refers to the process of spreading out the cost of intangible assets, such as patents, trademarks, and copyrights, over a specific period. It allows businesses to allocate the expense of acquiring these assets gradually.

What is EBIT?

While this article refers to EBITDA, for certain businesses, such as equipment heavy businesses, EBIT can be a better valuation metric to use.

Compared to EBITDA, EBIT leaves the deduction of cost for depreciation and amortisation from net profit.

Asset intensive companies are companies that require above-average capital to operate, for example, haulage companies or large construction businesses. Think companies in which regularly purchasing new equipment is necessary to maintain a consistent revenue stream.

How to Calculate EBITDA

Calculating EBITDA involves a straightforward formula:

 

EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortisation

Let’s consider an example to understand how the formula works. Suppose your company has a net income of £220,000, pays £40,000 in taxes, incurs £20,000 in interest expenses, and has £40,000 in depreciation costs.

The EBITDA calculation for your business would be:

 

EBITDA = £220,000 + £40,000 + £20,000 + £40,000 = £320,000

This doesn’t necessarily give you a true picture of the value of your business though…

How to get a true business valuation

Adjusted EBITDA is simply EBITDA with further adjustments made to better reflect the profit that will be made by a 3rd party after purchase. These adjustments can vary from company to company, but they typically include the below:

  • One-off payments or unusual items that do not reoccur annually such as grants or a profit on sale of assets
  • Discretionary expenses. These would be added back and must have nothing to do with the business and might include:
    • Owner’s health or life insurance
    • Owner retirement contributions
    • Personal vehicle expenses
    • Charitable contributions
    • Entertainment expenses
    • Salary payments to family members who will not be involved in the business once it isn’t family owned
  • If your Limited company owns the property it trades from you have to deduct the market value of the rent you would pay for this if you were a tenant
  • Cost of replacing the directors. Many owners take the bulk of their income as dividends. As result, you need to replace the salary currently paid with a figure representing the market rate for a replacement

Your adjusted EBITDA will now shows the likely profit that will be earned by a new owner.

The multiple

Adjusted EBITA is then multiplied by a suitable multiple.

The multiple to apply needs to consider a huge range of factors including:

  • How solid the customer base and recurring income stream is
  • Whether the company has potential for growth
  • Whether there is likely to be competition to buy

How to maximise the value of your business

There are some important numbers you need to be focusing on that will be help you maximise the value and it’s not reducing your overheads! You will never (and we can’t stress this enough) make a significant increase in profitability if you spend your time trying to reduce your overheads.

Our top tip is to focus on your gross profit. This can involves analysing your cost of goods sold (COGS) and finding ways to improve efficiency, negotiate better terms with suppliers, or enhance the quality of your products but the number one focus should always be revenue.

Here are our top tips and areas of focus that can help increase profitability and overall value:

Optimise Revenue

Look for opportunities to increase your top line by exploring new markets, expanding product lines, or targeting high-value customers. Implement effective marketing and sales strategies to drive revenue growth.

Adjust Pricing

Evaluate your pricing strategy to ensure it aligns with market conditions and reflects the value your products or services deliver. Consider conducting market research and competitor analysis to determine optimal pricing levels. This is where you are going to see the biggest impact on your bottom line.

We have a detailed article here on how to increase your prices without upsetting your customers.

Prioritise More Profitable Work

Identify which products, services, or customer segments generate the highest profit margins. By focusing on these areas, you can allocate resources effectively and prioritise activities that contribute the most to your bottom line.

Cost of Sale Savings

Look for opportunities to save on the cost of sale by optimising your supply chain, reducing wastage, or renegotiating contracts with vendors. This can help increase your gross profit margin.

For example, let’s say you run a manufacturing business. By analysing your EBITDA, you discover that a particular product line has a low gross profit margin due to high raw material costs. You can explore alternative suppliers or negotiate better pricing to improve profitability. Additionally, by identifying cost-saving opportunities in your production processes and optimising your sales efforts towards higher-margin products, you can increase overall value and profitability.

Book a 1:1 with us and maximise the value of your business 

EBITDA is a powerful metric that can provide valuable insights into your profitability. By understanding and leveraging adjusted EBITDA, you can maximise the value of your businesses.

Remember, understanding and applying financial metrics like EBITDA is just one piece of the puzzle. It is important to seek professional advice and tailor your approach to your specific business needs and industry dynamics.

A few select businesses each year benefit from us mentoring them on a 1:1 basis within our Breakthrough Growth Programme.

This programme is completely tailored to your business and your personal needs however, we have summarised the steps businesses usually take in our programme on our website here.

Some of the benefits to you include:

  • A more valuable, growing business
  • Improved profitability
  • Greater clarity over your personal goals and drivers
  • Greater confidence in the future of your business
  • Faster decision making
  • Improved employee retention and productivity

Due to the bespoke nature of this service, we have limited availability so if you are interested in becoming one of our exclusive clients, please contact us to find out if you qualify for our strategic growth coaching.

Call 01474 853 856 or email enquiries@a4g-llp.co.uk.

Book a 1:1

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