November 24, 2024
A Small Business Owner's Guide to EBITDA
As a business owner, you probably know your annual sales by heart. You might even have a good handle on your bottom-line profit. But here is what most small business owners don’t realize: when it comes time to sell, buyers aren't looking at sales or profits – they're focused on your EBITDA, a measure of your business's true operating profitability.
This knowledge gap leads many owners to make costly mistakes during a sale like:
Overestimating the value of their business by 300-400% when using sales figures, causing them to reject great offers
Undervaluing their business by 50% or more when using net profit, leaving life-changing money on the table
Understanding these financial terms might seem daunting and overwhelming - but it doesn’t have to be. In this article we will teach you everything you need to know about measuring your business’s true profitability and how to apply it to valuing your business.
In this article, you'll learn:
What EBITDA is and why buyers care about it more than other metrics
How to calculate your base EBITDA from your financial statements
Which adjustments can legitimately increase your EBITDA
How to use EBITDA to estimate your business's market value
How to increase your EBITDA (and the value of your business)
What is EBITDA?
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) reveals your business's true operational performance by stripping away factors that can vary widely between companies.
Let's look at a real example of two manufacturing businesses to see why a correct EBITDA calculation matters so much:
Metric | Manufacturer A | Manufacturer B | |||
---|---|---|---|---|---|
Net Profit | $300K | $300K | |||
+ Interest | $200K | $50K | |||
+ Taxes | $150K | $100K | |||
+ Depreciation | $350K | $50K | |||
EBIDTA | $1M | $500K |
Despite showing identical net profits, Company A is actually twice as valuable to buyers! Why? Because their net profit is impacted by:
Higher interest payments (which a new owner could refinance at a lower interest rate or avoid using debt altogether)
Higher taxes (could be due to a different tax jurisdiction or business structure)
More investment in equipment in the past (showing up as depreciation, even though not a cash expense)
These factors mask the fact that Manufacturer A's core operations generate twice the cash flow of Manufacturer B.
💡 Quick Tip: Your business's EBITDA can be 2-3x higher than the net profit you reported on last year's tax return. This is why knowing your true EBITDA is crucial when talking to potential buyers.
How to Calculate Your EBITDA
EBITDA adds back four key expenses to your net profit. Here's why each one matters:
Component | Why It's Added Back | ||
---|---|---|---|
Interest | Separates business performance from financing choices. Two identical businesses could have different interest expenses just because one owner borrowed while another used savings. | ||
Taxes | Varies by structure (LLC vs. S-Corp) and tax strategy, not business performance. An acquirer might pay no taxes due to their structure or existing tax losses. | ||
Depreciation | Non-cash expense that doesn't reflect current performance. A $1M machine shows as $100K annual expense for 10 years, though cash was paid only once. | ||
Amortization | Similar to depreciation but for intangible assets. Doesn't affect current cash flow. |
⚠️ Common Mistake: Don't forget to include all interest payments, including those on equipment loans and business lines of credit.
Making Adjustments to Your EBITDA
After calculating your base EBITDA, the next critical step is identifying legitimate adjustments. These adjustments help present a more accurate picture of your business's true earning potential under new ownership.
There are two primary types of EBITDA adjustments:
1. Non-Business Expenses
These are personal or family expenses that many small business owners run through their company for tax advantages. While this practice reduces taxes, it also artificially lowers your EBITDA. Common examples include:
Personal vehicle expenses
Family members on payroll
Personal travel or entertainment
Personal insurance policies
Owner's salary above market rate
Home office expenses
2. Non-Recurring Items
These are one-time costs or revenue spikes that don't reflect your business's normal operations. Including these would distort the true "steady state" picture of your business. Examples include:
Legal settlements
Moving expenses
Equipment repair/replacement
COVID-related impacts
Natural disaster costs
One-time project revenue
Startup costs for new locations
Real-World Example: From Base to Adjusted EBITDA
Let's look at how these adjustments can play out for a manufacturing company:
Category | Amount | Explanation | |||
---|---|---|---|---|---|
Base EBIDTA | $800,000 | Before any adjustments | |||
Add Backs: | |||||
Owner's Salary | +$150,000 | Excess above market rate for CEO | |||
Family on Payroll | +$80,000 | Non-working family members | |||
Personal Vehicles | +$45,000 | Two luxury cars and related expenses | |||
Legal Settlement | +$100,000 | One-time lawsuit defense costs | |||
New Location Costs | +$75,000 | One-time expenses for second facility | |||
Subtractions | |||||
COVID Grant | -$90,000 | One-time government assistance | |||
Large Project | -$110,000 | Non-recurring contract profit | |||
Adjusted EBIDTA | $1,050,000 | True earnings potential |
💡 Quick Tip: Document these adjustments throughout the year with clear explanations and supporting evidence. Buyers will scrutinize every adjustment during due diligence.
⚠️ Warning: While it's important to identify all legitimate adjustments, being too aggressive with add-backs can damage your credibility with buyers. Each adjustment should be clearly defendable and well-documented.
What Makes a Good Adjustment?
Strong EBITDA adjustments share these characteristics:
Clearly personal or non-recurring in nature
Well-documented with supporting evidence
Would definitely not continue under new ownership
Conservatively calculated
Common industry practice
Using EBITDA to Value Your Business
When valuing your business, industry matters - a lot. Just like homes in different neighborhoods command different prices, businesses in different industries typically sell for different EBITDA multiples. Think of an EBITDA multiple as a price tag for your business based on its yearly profits.
Here is a simple example:
If similar businesses in your industry typically sell for 4-5x times EBITDA, and
Your business makes $1 million in Adjusted EBITDA, then
You might expect to sell your business for around $4-5 million.
With that said, even companies within the same industry can trade at significantly different multiples, depending company specific characteristics such as revenue recurrence, customer diversity, and others.
To illustrate this point, let’s take a look at the plumbing industry, which typically attracts valuation multipliers of 3-6x - but which one is the most appropriate for your business?
Plumbing Company A | Plumbing Company B | ||||
---|---|---|---|---|---|
Revenue | $10M | $20M | |||
EBIDTA | $2M | $2M | |||
Services | 100% commercial service & maintenance | 100% commercial new construction | |||
Business Model | • Annual maintenance contracts with office buildings • 24/7 emergency repair services • 200+ commercial buildings under contract • Largest customer is 5% of revenue | • Project-based work for general contractors • Competitive bid process • 3 contractors represent 70% of revenue • Highly dependent on new building | |||
Multiplier | 6.5x | 2.75x | |||
Value | $13M | $5.5M |
The service business is worth more than twice as much because:
Predictable revenue: Long-term maintenance contracts vs. project-based work
Customer diversity: 200+ buildings vs. 3 main contractors
Economic protection: Buildings need maintenance in any economy
Figuring out the right multiple for your business can be challenging (here is an article that explains how to do it). But as a general rule of thumb, here are some of the factors that can increase of decrease the valuation multiplier for your business:
Think of these as the "curb appeal" factors for your business:
Size matters: Generally, larger businesses command higher multiples
Growth trajectory: Consistent growth trends can push you toward the higher end
Competitive position: Strong market share or unique advantages boost multiples
Customer diversity: Less reliance on any single customer improves valuations
Management strength: A strong team that will stay post-sale adds value
💡Quick Tip: An experienced M&A advisor will be able to give you a better estimate of what your business is worth based on their data on past similar transactions, as well as their deep understanding of how buyers view and assess acquisition opportunities in your industry.
Making EBITDA Work for You
Improving and tracking your EBITDA doesn’t have to be complicated. By implementing a few straightforward practices, you can consistently monitor your business’s operational profitability and set yourself up for long-term success. Here’s how:
Monthly Action Plan
Make these steps part of your routine to track and improve EBITDA consistently:
Calculate and Track Your EBITDA Quarterly:
Pull your profit and loss (P&L) statement.
Add back interest, taxes, depreciation, and amortization to calculate EBITDA.
Compare results with previous quarters to identify trends and areas for improvement.
Focus on EBIDTA-improving activities:
Optimize pricing strategies (experiment with price increases for high-demand or premium offerings)
Identify opportunities for cross-selling to your existing customers
Streamline operations where possible and invest in automation of manual processes
Negotiate discounts from vendors
Document everything that affects EBIDTA
Keep clear records of unusual expenses
Track personal expenses run through the business
Note any family member salaries
💡 Quick Tip: Use a simple spreadsheet to log your EBITDA calculations and adjustments regularly. This will save time and ensure accuracy during due diligence. Alternatively, engage a professional CPA to keep the records clean and up to date for you.
Conclusion: Know and Grow Your EBITDA
Understanding and optimizing your EBITDA isn't just about better business metrics – it's about maximizing the value of your life's work. Every $10,000 improvement in EBITDA could add $30,000-$60,000 to your final sale price. This is real money in your pocket when you finally decide to realize the value you've built.
Summary:
EBITDA, not revenue or net profit, determines your business's true value
Legitimate adjustments can significantly impact your valuation
Regular EBITDA tracking helps identify value-building opportunities
Proper documentation of adjustments is crucial for credibility with buyers
Industry-specific multiples determine your final business value
Next Steps
Whether you’re just starting to explore your exit options or ready to meet potential buyers, we’re here to help you guide your path forward.
Schedule a free confidential consultation with an OffDeal M&A advisor to:
Understand your business’s current market value
Explore actionable steps you can take to increase the value of your business today
Learn about the current buyer demand for your business
Schedule call with OffDeal M&A Expert
Preview potential buyers, for free
OffDeal leverages advanced technology and expertise to help small business owners achieve the same quality of M&A service previously reserved for large corporations. Our mission is to ensure every business owner has the opportunity to maximize their value when they're ready to sell.