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The Finance of Startups: For Dummies Part 11 – To EBITDA, Or Not to EBITDA?... That Is The Incomplete Question


EBITDA. I’ve heard this term plenty of times over the years, and yet, I don’t know why it’s so important. Yes, I know EBITDA stands for “Earnings Before Interest, Tax, Depreciation, and Amortization”. However, of its importance, I know little of.

As I’ve done in the past, today, I’ll take a look at EBITDA as part of my series on Finance of Startups (yes, two posts in a row!).

The importance/ relative reasons for EBITDA:
  • Quick and dirty estimate for cash flows
  • Interest and taxes are omitted in EBITDA as they can be heavily impacted by losses from previous years, debt financing (argued should not be used to measure the inherent value of a company), etc.
  • Depreciation and amortization are non-cash items that can be heavily influenced by company decision-makers
  • Can be used to measure against other companies’ EBITDA as a proxy for cash flows and across industry averages
However, there are many critics to EBITDA:
  • Does not include working capital considerations (cash outlays for inventory, for example)
  • Interest and taxes are cash outflows, and with their removal, may over-value a company. And because they’re not included, EBITDA is not a true measure of a company’s cash flows
  • The omission of depreciation and amortization, though non-cash, fails to recognize useful lives of long-term assets and their eventual need to be replaced (think machinery which will eventually fail)
  • Not Generally Accepted Accounting Principles mandated (non-GAAP). As such, companies provide EBITDA as wanted, and because Earnings, Interest, Tax, Depreciation, and Amortization can be calculated differently from company to company, EBITDA can be massaged to tell a rosier picture and not be an apples-to-apples comparison
Investors like to use EBITDA as part of their valuation calculations of startups (okay, companies in general); though, like any metric, EBITDA may provide insight in a singular way. To overcome its shortcomings, EBITDA should be used in conjunction with other relevant metrics and ratios.

Resources:

Comments

  1. EBITDA is really just a shortcut that tells investors a lot about a company. It's better than revenue, because it recognizes that revenue can be misleading if costs are way out of line. For example, if I spent $1B dollars for $1M in revenue, then the business is wildly unprofitable. No one looking at EBITDA would buy that company, but someone looking at revenue might. Alternatively, EBITDA does not account for interest, taxes, depreciation, or amortization, because to a smart business person with a great accountant, those parts of the business can be widely manipulated to produce whatever outcome the business owner needed. Apple have billions of dollars "trapped" overseas for a reason: lower taxes.

    Use EBITDA to start a conversation, but never to finish a deal. Connect with me if you need any more help: https://www.linkedin.com/in/daviddurant.

    David Durant

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    Replies
    1. Well put, David. Thanks for sharing!

      Delete

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