What is missing from EBITDA?

Working Capital

When a business is sold, Working Capital (Cash, Accounts Receivable Inventory, and Accounts Payable) are usually included in the sale for businesses with a value over $1 million and not included for businesses worth less than $1 Million.   When it is included, a “normal” amount of Working Capital is included, but the term “normal” varies greatly and is part of the negotiation process.  The Working Capital is a measure of cash a business needs to support day-to-day operations, but when evaluating a company for an acquisition, not only is total Working Capital important, the change in working capital before Close should be watched as well.  A Working Capital Target should be negotiated at the time a LOI is signed.

Relying solely upon a multiple does not take into consideration additional working capital a buyer will need for the newly acquired business, post-close. Working Capital is an important consideration to make when a business is being bought or sold regardless of the EBITDA multiple used for value.

Real Estate Improvements – Tenant Improvements

A Purchaser of a business generally will assume a location, whether through a lease or a purchase of property.  Tenant improvements are often missing from EBITDA multiples, yet he cost of the improvements are often an expense post-close as the acquiring party invests in paint, signage and other improvements to ensure the acquired location matches the Purchasers standards. When evaluating the cost of an acquisition, if tenant improvements are anticipated, they should be included as an expense when calculating EBITDA.

CAPEX

Future CAPEX or capital expenditure needs are not included in the EBITDA of a business.  These are the funds a company uses to buy or upgrade the physical assets of the business. If you have a business that has very little fixed assets, it isn’t important, but if you have a business which is capital asset intensive (trucking or manufacturing) the depreciation is a cost that should not all be added back when the company considered is a capital-intensive business.  In these cases, EBIT (Earnings Before Interest and Taxes) would be a better multiple to use for these types of businesses.

CAPEX represents depreciable assets, yet, these expenses are removed from EBITDA. The problem with this is CAPEX is a very real cost, and a critical consideration when evaluating a business. Because of this, it is important to include projected CAPEX expenditures post-close when evaluating the entire value of the business.

Conclusion

Multiples are a quick and easy way to evaluate and compare multiple companies across an industry. EBITDA provides a “tried and true” method to calculate true cash flow, but both can be misleading, and, when not fully understood, can be misleading.  When an advisor is evaluating the merits of an acquisition, it often pays to devote the extra resources to develop a financial model that takes CAPEX, Tenant Improvements, and Working Capital into consideration.

Founder, My Biz Value who spends time in the trenches, managing mergers and acquisitions of companies with high growth potential. Rick Krebs, dubbed an “expert sale-side advisor” by Forbes, developed the My Biz Value system because he’s passionate about helping entrepreneurs and business owners achieve successful transactions. He’s also obsessed with timeliness, accuracy and value.