Knowledge base item

What is EBITDA? Why is it important in an acquisition?

The importance of EBITDA in a business takeover

EBITDA is the abbreviation for Earnings Before Interest, Taxes, Depreciation and Amortization. It is a measure of a company's profit from operating activities, excluding the cost of financing (balance sheet ratios).

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How do you calculate EBITDA?

The EBITDA can therefore be calculated by starting with the net profit and adding the net interest expenses (interest costs - interest income), income taxes, depreciation and amortisation. In short:

EBITDA = Net earnings + net interest expense + income taxes + depreciation + amortization

What is the EBITDA used for?

EBITDA gained a more prominent role in the merger and acquisition world from the 1980s. From that time onwards it was mainly used for leveraged buyouts, a takeover that is largely financed by debt. The EBITDA namely showed whether companies could cope with a heavier debt structure after a restructuring.

Today, it is still often used in takeovers. Using EBITDA instead of net profit makes it easier to compare companies. It shows how the company performs based on its operations, without taking into account how it is financed. Companies that perform similarly can end up with completely different net results, because one company is financed with more debt than another. By using EBITDA, you eliminate the financing element.

But why is eliminating the funding element so important?

During an acquisition the company is often delivered cash and debt free, which means that it is free of cash and debts. This allows the new owner to determine the extent to which he uses loan capital to finance his newly purchased business.

Since EBITDA is also an important yardstick for the value of a company, it is often normalised during the preparation of an acquisition process. This normalisation means that certain costs or revenues that are not representative of the actual and current state of affairs are removed from the profit and loss account. These can give a distorted picture of how the company is actually performing. Examples are too high or too low management fees, non-recurring legal costs or non-recurring book losses.

During an acquisition process it is important to look critically at the EBITDA and the applied normalizations, but not every company uses the same criteria. The advisors of Florijnz can support you throughout the process both in buying a company or selling your company in this analysis.

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Marieke Klaassen
Marieke Klaassen van BeurdenPartner