EBITDA and Small Business by Dan Pellegrino

One of the terms that a buyer should beware when used in conjunction with any small business transaction is EBITDA (Earnings Before Interest Taxes Depreciation and Amortization). This value is often a dangerous and misleading number, due to the fact that it is often confused with cash flow. Recently we sent our clients a memo filled with quotes from Warren Buffett on this subject. Here are two of my favorites. "Many companies abuse the EBITDA method when reporting their earnings in order to put a better spin on their financial results. A management team that tries to convince others that depreciation isn't an ongoing cash expense may start to believe their own propaganda." "References to EBITDA make us shudder. Too many investors focus on earnings before interest, taxes, depreciation and amortization. That makes sense only if you think capital expenditures are funded by the tooth fairy." Some people mistakenly look at the true accounting definition of depreciation and assume it's a non-cash expense so it really increases cash flow. In most small businesses it is rare to lay out a huge sum of money in advance and then write it off over three, five or seven years. If nothing else, depreciation is your deduction for the principal portion of a bank loan (which is not deductible). Mr. Buffett also points out that depreciation is the worst kind of expense there is as you put out the money upfront and get the write-off over time. You are investing in assets that will bring future returns. In a stable business that has assets there is an ongoing need for new equipment, vehicles, fixtures, etc. In a growing business there is a tremendous need for more assets. Illustration Look at this simple example. You start a business that requires trucks to deliver the product to your customers. The first year you buy one truck. The business grows and by the second year you need a second truck. The same thing happens for the next few years. By the end of the fifth year you have five trucks. Let's assume these trucks have a five year life. In the sixth year you will need to replace truck number one (and so on). Your depreciation is a real cost. It is nothing more or less. And if your business continues to grow? Perhaps by the sixth year you'll need an additional truck, now you're laying out money for two trucks. It's even more of a real cost. It doesn't matter whether it's trucks, machines, computers or any other asset, the cost of it is not "cash flow." Adjustments There are always some "exceptions to the rule." I offer these in the context of valuation or a buy-sell transaction. A large investment was recently made and taking advantage of the Section 179 deduction, let's say $100,000 was expensed. However, that investment will last five years (like our trucks above). An appraiser or business buyer may recast or adjust that $100,000 to $20,000 over five years to accurately reflect the life of the asset. The company has invested heavily in assets over the last few years and has capacity to double volume without any more asset purchases. An appraiser or business buyer may, again, adjust the depreciation to accurately portray what the profit would have been if there was not the investment in this "excess" capacity. The full value of the assets is included in the purchase price. Recently we did a valuation assignment on the sale of a small business. The seller included all the assets and was paying off the bank loan for those assets from the proceeds. There was a legitimate case to be made that depreciation could be "added-back" to the cash flow. The buyer would assume that same cost, only as part of his acquisition debt. If he had assumed the asset loan the depreciation would be a legitimate expense and the price would have been that much lower. In the first two examples, don't forget that while this will increase last years cash flow it will decrease future years projected cash flow. Finally, here's an example of what is not a legitimate adjustment. The five-year history of the manufacturing business showed annual depreciation of about $125,000. This amount was added back to profit. There was no reason given as to why there would be no more asset purchases in the future. In fact, given the improving technology, it was evident there would always be new equipment needed to keep competitive. A buyer basing the price on this inflated profit figure will be in for a big surprise when he or she finds out they really do need to spend six figures per year on equipment. Conclusion The only accurate reflection of a business' value is the profit. The profit after fair market owner compensation and all legitimate expenses, including depreciation. It's a real cost of doing business. Be wary when you see any calculation that includes it as part of "profit." Yes, there are some adjustments (minor exceptions) but for the most part, if it's added-back it means someone is trying to artificially inflate the cash flow and/or profit of the firm. If buying a business it could lead to serious cash flow problems. If selling a business, and the buyer has cash flow problems you might have cash flow problems (i.e. your payments get interrupted or in a worst case scenario you pay legal fees to straighten it out). Dan Pellegrino Partner On-Call LLC 310-684-3923