Hi. Brandon Davis with Davis CPA Group. Today I’m going to talk about EBITDA. You may be like, “What’s that? Is it a foreign language?” No, it’s actually an acronym, and it’s an acronym that stands for earnings before interest, taxes, depreciation, and amortization, and this is used by banks, and investors to look at the cashflows that are generated by the operations of a business when you look at either making an investment or determining if you can pay back a loan.
Let me walk you through how EBITDA’s calculated, and what it’s used for. Again, EBITDA, I’m going to write it up here. Earnings before interest, taxes, depreciation, and amortization. That’s basically what it stands for. Let’s say, “All right.” We look at our income statement over here, and again, if you’ve not seen my videos on income statements and balance sheets you might take a quick look at that, because that’ll make some of this make a little more sense, because I’m going to go kind of high level through that part of it.
Let’s say, for example, I make 100,000 dollars over here in total sales, and I’m just going to condense all the expenses. Maybe you have utilities, insurance, other operating expenses, but let’s say my total expenses were 50,000 dollars, okay?
Then I’m going to highlight a couple other expenses. One of the major expenses you may have in a business is interest expense, so lets just say this is all operating. Your all operating, 50,000, just lumping them together. Interest expense, let’s say that’s 15,000, okay?
And then we also took what’s called depreciation expense. Well, if you look at my video about balance sheets and income statements, how those play together, when you have assets that are longer lived assets on your balance sheet that you’ve invested in the past, every year you get a little bit of expense against the cost basis of those assets called depreciation.
It’s what’s concerning non-cash expense, because you didn’t spend the 15K in expenses that we’re looking at here, or let’s say maybe it’s higher than that. Let’s say it … nah, 15K is a good number. 15,000 in expenses there. Now we’re up to 50,000 operating expenses, 15,000 interest, and 15,000 depreciation, so our total expenses is right at 80,000 dollars. That’s total expenses.
Our net income, then, or my earnings is 30,000 dollars. Or, I’m sorry, 20,000 dollars. 100,000 dollars inus 80,000 dollars, so it’ll give you 20,000 dollars in earnings, so I put that up here. There’s my earnings.
This is earnings before interest, there’s my interest, the 15K. Taxes. Let’s consider this a flow through; maybe it’s an S corporation. Doesn’t pay taxes at the entity level, no taxes in these expenses, so we can ignore that one.
If it was a C corporation where they had taxes as an expense item, we’d put it here in this tax item, but right now we’ll put zero because we don’t have any. Oh, we’ve got some depreciation expense, so there’s 15K there, and amortization. Amortization is very similar to depreciation. We’re not going to get into the details of it right now, but we’re just going to call that zero for now.
Now you look: we’ve got 20,000 of earnings. We got 15,000 interest, 15,000 depreciation. There’s another 30K to be added back to my 20, so my EBITDA number is basically 50,000 dollars. 30 plus the 20. You look at this from that standpoint and go, “Oh, that’s kind of cool. That’s what for?”
Well, this is telling me that, based on my current capital structure of having some leverage and some non-cash expenses, my earnings before interest, taxes, and depreciation, which is a number we used in to do some ratio analysis is 50K, so what the bank’s going to do is they’re going to say, “Okay, cool. We’re going to take this 50K and we’re going to look at … ”
Say, for example, I was in a situation where I wanted to borrow money. One of the things that banks look at is what’s called your debt service coverage ratio, DSCR. That’s what they call it, and a healthy debt service coverage ratio is somewhere in the neighborhood of about 1.15 to 1.20. That’s really what you need to be kind of minimum and above.
Just to say you had the ability to cashflow the debt. Well, how they calculate that, basically, is they take your total debt payments, your principal and interest together, and basically what you do is you divide that into your EBITDA, or a high enough number here to get to that 1.15 or 1.2 number.
Basically, if I looked at 50,000 dollars in total revenues, or EBITDA, rather, after we factor in our revenues and such … let’s say their total debt payments is 40,000 dollars. That would get us a debt service coverage ratio of 1.25, so this tells me that they could cover total annual payments of 40K. They could cover those pretty easily with 50,000 dollars of profits.
Basically, the bank uses this debt service coverage ratio as a way to figure out, “Do you have enough cashflow from your operations to cover the debt that you’re after?” You know, I try to tell my clients I like to see them a little bit higher than that.
You know, this is, again, a minimum threshold at the 1.15 to 1.2, but that’s where EBITDA is used. Another measure that EBITDA is used for is looking at the valuation of a business, and so if we go back to this same scenario here and say … someone might look at investing in a business and say, “Okay, what’s the enterprise value? What’s the value of these cashflows?”
They’re going to do a couple of things. One, they’re going to look at a trend. They’re going to look at probably the most current five years. They’re going to look at certainly a trailing 12 months, to see how you’ve been trending, whether you’re going up or down, but then they’re going to look at your EBITDA from a period of time.
Maybe it’s three, five years. They’re going to weight that EBITDA, meaning they’re going to put more emphasis on your EBITDA and on those current fiscal year. Maybe they’ll weight that five times, and four, three, two, one, back five years, take that weighted EBITDA number, and then apply some sort of multiple to it.
“Man, a multiple? What’s that mean?” Well, the multiple is the value driver from the standpoint of saying … and it depends on a couple things. One, it depends on how strong other factors of your business are. Your balance sheet, your customer base, what industry you’re in. But what it does at the highest level, looking at it very simply, takes your EBITDA number times maybe two, or three, or four. Whatever it might be based on all of those other factors. It’s more art than science a lot of times.
But that EBITDA number is the base number that’s used to figure out the value of your business, whether it’s a two times multiple or two times EBITDA, then your business is worth 100K. Three times, maybe it’s 150, or 200,000, so this is just, again, a baseline tool or baseline number in both the utilization of looking at what banks look at from a debt service coverage standpoint, but also looking at the clash flows of the business, and looking at maybe determining a value or your enterprise or value of your business.
A lot more goes into it than that. I basically to wanted to talk about what EBITDA was, how it’s kind of used, and really talk about it from a high level perspective.