What is EBITDA and why is it important to franchise owners? (5 minute read)
Whether you intend to build a business to sell or to provide income for your family, measuring and managing EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) is a key to meeting your goals. For some, EBITDA (ee-bit-dah) is odd to say and even more difficult to define. Hopefully this article takes the mystery out of EBITDA and helps franchise and business owners understand its importance in meeting goals and objectives.
EBITDA starts with net income and adds back interest, taxes, depreciation and amortization. It is used to, in effect, measure the cash flow of a business regardless of capital and tax structure. For illustration purposes, let’s use Bob’s Deli, a fictional entity based on an actual franchisee.
First, take net income and add back interest expense to remove the effect of an entity’s capital structure. This puts all entities on the same footing regardless of the amount of debt carried on the balance sheet. By adding back interest, entities with debt financing can be compared to entities that are capitalized with little or no debt. Bob’s net income last year was $125,000 and interest paid on an equipment loan totaled $3,600 for the year.
The second step is to add back income tax expenses. This is important because entities can be structured differently for tax purposes. “C” corporations pay corporate income taxes while “S” corporations and partnerships pass-through earnings to owners who are taxed on the earnings on their individual tax returns. By adding back taxes to net income, we remove the effect of an entity’s tax structure on earnings. Since Bob is structured as an S Corporation, there’s no income tax expense to add back in our example.
Our third step in arriving at EBITDA is to add back depreciation and amortization. Depreciation is how businesses expense the cost of fixed assets such as buildings, leasehold improvements and equipment over their useful lives. Amortization is a similar concept of expensing intangibles such as franchise fees, goodwill and noncompete agreements over time. Adding back depreciation and amortization removes the effect of depreciation and amortization methods and useful lives as well as the age of the business. In Bob’s case, depreciation and amortization expenses for the year were $14,000 and $7,000, respectively.
Having covered the calculation and concept, now we ask why is EBITDA important to franchise and business owners? Whether building a business to sell or to support your family, managing EBITDA is critical to meeting your goals. A higher EBITDA means more income for owners and a higher valuation of the business.
Investors and bankers look at EBITDA for similar, but slightly different purposes. For investors, EBITDA is the basis for valuing an entity. For cash investors, EBITDA indicates how quickly the business will pay back their investment in the form of dividends or distributions. If an investor seeks a five-year return on investment, the business value in the investor’s eyes would be no more than 5 times EBITDA. In this case, the valuation of Bob’s Deli generating $150,000 per year of EBITDA could be as high as $750,000 to meet the investor’s payback period requirement. Although many other factors can influence the price an investor is willing to pay for a business, EBITDA indicates whether that value will meet the criteria for return on investment.
For bankers, EBITDA indicates the entity’s ability to repay debt. Bankers generally look at the debt coverage ratio of the business. From a banker’s perspective, EBITDA should be at minimum of 1.2 times the debt payment of the business. For example, a franchise with a monthly loan payment of $5,000 should generate a minimum of $6,000 EBITDA per month. Even with a debt coverage ratio of 1.2, the bank will most likely require personal guarantees of the owners along with other potential requirements. A higher EBITDA and thus a higher debt coverage ratio, may reduce interest rates and other bank requirements.
If you are looking to purchase an existing franchise, you may see the term “Seller’s Discretionary Earnings”. Don’t mistake seller’s discretionary earnings for EBITDA. Although SDE is a similar concept to EBITDA, it may add back salaries and wages paid to owners along with other discretionary or personal expenses paid by the business.
While franchisees should be compensated for the time they work in the business, adding back an owner’s compensation in order to establish the entity’s value is a faulty concept. It can lead to inflated valuations, high debt service and unrealistic earnings expectations. Owners should be compensated for their work in the business based on what it would cost to hire someone to perform the same job. However, compensation of owners should not be added back in the valuation process unless the owners have been clearly paid more than market value for the job they perform in the business.
If you want to learn more or have questions specific to franchises, technology or accounting, please contact me at 844-309-4930 or via www.linkedin.com/in/tom-g-porterfield-cpa.