At a recent risk management seminar, one of the participants spoke about how their controller received an email from the CEO of their company asking him to wire transfer some funds for that day. What the controller didn’t know is that someone had hacked into the company’s email system, and had been monitoring the style and timing of the CEO’s emails. The hacker then sent an email from the CEO’s mail account to the controller requesting the wire transfer. Fortunately the controller, suspecting that something was not right, walked down to the CEO’s office to confirm that he really did want to make this transfer. The CEO knew nothing about the transfer request, so the transfer was not made. Not all companies these days are this fortunate. In the past year there have been many of these email schemes that have convinced people to wire or ACH money to thieves who prey electronically on businesses of all sizes.
So what does cyber-crime have to do with the topic of managing cash flow complexities and EBITDA? Cyber-crime is just one of hundreds of risks that businesses face related to their cash flow. A few years ago this was rarely a risk. Today’s it’s a much higher risk that is rarely publicized. Losing significant amounts of cash from unplanned, and sometimes uninsured events can be a business owner’s worst nightmare. Hits to cash flow and EBITDA can have severe negative impacts, not only on operations but also on the value of your business.
A short background on the “what” and “why” of EBITDA. EBITDA (sometime pronounced as E-bit-duh) is an acronym that means Earnings Before Interest, Taxes, Depreciation and Amortization. When an investor looks at purchasing a company, if that investor only looks at the amount of cash flow generated for the year, that investor may not put a proper valuation on the company.
For example… if there was a $1 million increase in cash for the year, someone might think that appears to be a good thing. But if the reason for the $1 million increase in cash is because the company borrowed $2 million on it’s credit line and then lost $1 million from operations, then that’s not good.
As another example, if the same company’s cash went down by $1 million in a year, someone might think that’s a bad thing. But if the reason for the decrease is because they had 50 new contracts and paid $2 million in cash to increase inventory and fixed asset to accommodate the growth, and on top of this they generated $1 million in cash from net income…then that overall decrease in cash is not necessarily a bad thing.
EBITDA is a way for an investor to look deeper into to the sources and uses of cash and also to more easily compare one company to another. Let’s briefly look at each component of EBITDA to illustrate this:
- Earnings. This is the net income reported on a company’s income statement.
- Earnings Before Interest. The reason that EBITDA ignores interest expense is because two companies may be doing the same from an operations standpoint, but if one entity is capitalized differently, the interest expense will skew the net earnings. For an example, if the first organization has $2 million in earnings before interest, but has a large debt burden, it will show reduced net income compared to an organization with the same of amount of earnings before interest that has no debt. If you were only buying the assets and related goodwill of both companies (and not assuming any debt), then you would want to look at earnings before the interest expense (as on a go-forward basis, historical interest expense would not be relevant to the value you placed on both organizations).
- Earnings Before Interest and Taxes. The reason that tax expense is deducted in the calculation of EBITDA is because historical taxes paid may also be irrelevant to the value to be placed on the company. For example, let’s assume Company A has $2 million in pretax income. If Company A, is a C-Corporation, then pretax income would be reduced by the amount of tax expense to the C-Corp in the computation of that company’s net income. Let’s assume Company B is a partnership or an S-Corporation and also has $2 million in pretax income. Because this $2 million in pretax income would be passed down to the shareholders to be taxed at the shareholder level, the reported earnings for Company B would be $2 million. Both Companies A and B did the same in terms of pretax income, so if you look at earnings before tax you usually get a more apples-to-apples comparison between the two.
- Earnings Before Interest, Taxes, and Depreciation. The reason that depreciation is deducted in the calculation of EBITDA is primarily because depreciation has no affect on operating cash flows. Let’s say that Company A has $2 million in earnings before depreciation and has $800,000 in depreciation expense on all of it’s brand new fixed assets (so $1.2 million in earnings after depreciation). If they were depreciating all of these brand new assets over 3 years, then in the fourth year (all things else remaining equal) if they are still doing $2 million in earnings but have no depreciation expense they would have a net of $2 million in earning after depreciation. The increase from $1.2 million to $2 million is a sizeable jump in net earnings, but the difference has no effect on cash flow. Although in doing a valuation of a company you need to look at the value of fixed assets and the timing of future capital expenditures, historical depreciation rarely affects the value of an organization.
- Earnings Before Interest, Taxes, Depreciation and Amortization. Amortization expense is excluded in the calculation of EBITDA for essentially the same reason that depreciation is excluded. Depreciation is a book entry to record the estimated declining value of a fixed asset over the asset’s useful life. Amortization is a book entry to record the estimated declining value of a tangible asset. Both depreciation and amortization are a very broad way of recognizing that many assets values decline over a period of time. However as many assets (tangible and intangible) may actually increase in value over time, this is why the accounting profession has moved towards Fair Value reporting and presentation (which is another discussion for another day).
So why is EBITDA so important compared to changes in cash flow in the valuation of a Company?
Although increasing the amount of cash that eventually can be distributed to investors or reinvested in the business is a critical goal, EBITDA helps to define in a broad sense the organization’s ability to generate cash flows from true operations.
If a company is building up a lot of cash, but it’s EBITDA is low, the reasons for the cash buildup may be due to taking on new debt, reducing inventory levels too low, not paying vendors timely, etc. These are things that may not be healthy in the long-run for the company.
If a company is having lower cash balances but a high EBITDA, the reasons for the cash decline may be due to cash being used to get inventories to a proper production level, cash generated from high operating earnings being used to pay down debt to mitigate ongoing risk, etc. These are things that are more healthy for the company.
EBITDA in Valuing a Business
As companies are bought and sold, you’ll usually hear three terms in one mathematical formula: EBITDA times the Multiple = The Sales Price (or Company Valuation).
- EBITDA – As mentioned above, this is this different way to look at the earnings of organizations by deducting out things like interest, taxes and depreciation from net income.
- Multiple – Is simply the amount that you multiple your EBITDA by to arrive at the Sales Price.
- Sales Price or Value – The amount your company is valued at, or the price for which it is sold.
So let’s say that your company has $3 million in annual EBITDA, and buyers are willing to pay a 4X multiple, then your company may be worth $12 million ($3 million X 4).
If you are able to improve EBITDA to $5 million and investors are still willing to pay a 4X multiple, then your company may be worth $20 million ($5 million x 4).
If there is a significant amount of risk to your business, or you are not adequately prepared to sell your business (e.g. if you don’t have all your ducks in a row with respect to operations, intellectual property and a hundred other factors) and buyers are only willing to pay a 2X multiple (e.g. $5 million in EBITDA X 2 = $10 million), you may only get 1/2 of what a lower risk company’s valuation may bring.
Notice what’s missing from the equation? The increase or decrease in cash flow. Although cash flow is critical to an organization, it is more likely that your company’s EBITDA will be given considerably more attention in the valuation of your company. Properly managing your cash flows, along with operating profitability will, in time, improve EBITDA… but changes in cash flow themselves will usually not be as important in the eventual determination of the value of your company.
As noted above, cyber-security is one new threat to businesses and their ultimate values. A much older and wide-spread threat to companies is a lack of understanding of the relationship of EBITDA and Multiple. Having a greater understanding of these valuation components, formulating a plan to increase your company’s EBITDA, Multiple and Cash Flow over a period of time, and acting on this plan in a organized fashion should greatly contribute to the overall value of your company.
If you have any questions about or need help with improving cash flow, EBITDA and/or the overall value of the organization, please contact one of our 200+ partners throughout the U.S.
P.S. For more information about recent wire transfer fraud see FBI alert at: http://www.ic3.gov/media/2015/150122.aspx