What is EBITDA and why is it important to franchise owners? (5 minute read)
What is EBITDA?
Do you intend to build a business to sell or to provide income for your family? In either case, 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 helping 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. EBITDA measures 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. This removes the effect of an entity’s capital structure. Adding back interest allows entities with debt financing to be compared with 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.
Secondly, add back income tax expenses. This is important because entities are structured differently for tax purposes. “C” corporations pay corporate income taxes while “S” corporations and partnerships pass-through earnings to owners. The owners are taxed on the earnings on their individual tax returns. Adding back taxes to net income, removes the effect of an entity’s tax structure on earnings. Since Bob’s is structured as an S Corporation, there’s no income tax expense to add back in our example.
In our third step to calculate EBITDA, add back depreciation and amortization. Depreciation is how businesses expense the cost of fixed assets (i.e. buildings, leasehold improvements and equipment) over their useful lives. Amortization is a similar concept. Amortization expenses intangibles such as franchise fees and goodwill over time. Add back depreciation and amortization to remove the effects of differing methods, useful lives and the age of the business. In Bob’s case, depreciation and amortization expenses for the year were $14,000 and $7,000, respectively.
Why is EBITDA Important?
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.
An Investor’s Perspective
Investors and bankers look at EBITDA for similar, but slightly different purposes. Investors value businesses using EBITDA as a basis. For cash investors, EBITDA indicates how quickly the business pays back their investment in the form of dividends or distributions. For Investors seeking 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 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.
A Banker’s Perspective
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 needs to 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.
Seller’s Discretionary Earnings is not EBITDA
Buyers purchasing an existing franchise 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 adds back salaries and wages paid to owners along with other discretionary or personal expenses paid by the business.
It is good to compensate franchise owners working in the business. However, adding back an owner’s compensation in order to establish the entity’s value is a faulty concept. It leads to inflated valuations, high debt service and unrealistic earnings expectations. Owners should be compensated for their work in the business based on the cost to hire someone to perform the same job.
Porterfield & Company CPA
At Porterfield & Company CPA, we guide franchisees, pharmacists and small business owners to meet their business and financial goals.
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