Valuing a Business: What Are the Differences Between Net Income, EBITDA, Cash Flow & SDE?
For business owners who have spent years building their brand, it can be difficult to settle on an unbiased valuation. The financial health of a business is the key to understanding its value, but there is more than one way to measure it.
As a buyer or seller, understanding the value of a business means studying a brand new set of terms, including Cashflow, EBITDA, SDE and Net Income.
Understanding the Terminology of M&A
For many business owners, the first time that they hear any of these terms is when they are looking to sell. An experienced broker will help to demystify these terms by breaking them down into accessible concepts.
Cash Flow: Consistent cash flow paints a picture of success, but there is more to it than meets the eye! At a basic level, cash flow is just that: the amount of money that is flowing in and out of a business. Measuring cash flow helps in measuring short-term health.
Cash flow is relevant to certain calculations, but it doesn’t necessarily reflect profitability. It’s a great number to review, but this is not the final word on valuing a business. This is where we see the difference between SDE, cash flow and EBITDA.
“A short burst in cash flow can change the trajectory of your business for a few months or maybe a year, but this is only a short-term reflection of business health. The long-term health of your business should not be influenced by a few months, good or bad” shares Jason Brice.
Net Income: Similar to the way that cash flow measures the amount of liquid cash coming in, net income covers inflow minus the outflow, for a clearer bottom line of the business. Once you’ve taken the total sales of your business and subtracted the cost of goods sold, expenses, depreciation, interest, and taxes, what’s left is the “bottom line” (profit).
Net income focuses on profit alone, but when looking for a long-term valuation, this number doesn’t always reflect the facts. For example, in a year where a business faces extenuating circumstances like high-ticket equipment upgrades, restructuring, or other costly shifts, the remaining net income may not reflect the reality of standard operations.
EBITDA: This is the most commonly used metric for establishing the value of small to mid-sized businesses (typically $25 million or less). It’s an acronym that almost every business owner has heard, but the concept isn’t always clear. We refer to EBITDA, meaning: Earnings Before Interest, Taxes, Depreciation and Amortization. When creating a valuation, these metrics are added back into the bottom line of a company.
Cash flow and net income provide insight into different aspects of a business, but these metrics don’t cover all of the variable expenses businesses face throughout the year, namely the ITDA. Interest, taxes, depreciation and amortization are often viewed as flexible. Restructuring loans, for example, will change interest rates; taxes will vary from year to year, and non-cash values will fluctuate. Measuring EBITDA is important when valuing a business, but it can inadvertently hide key details. For example, this number doesn’t necessarily detail the current financial standing of a business, from a debt ratio perspective.
One of the main advantages of valuing a business using EBITDA is that it makes it possible to compare different businesses.
“One of the advantages of using the EBITDA method is that it makes it possible to compare different businesses on an “apples to apples” basis. The primary methods I use to compare valuations are EBITDA and SDE to create a clear, uniform comparison between businesses.”
Calculating EBITDA
The first stage of calculating EBITDA is to add interest and taxes to the net income.
- Net Income: $1,000,000
- Interest: $50,000
- Taxes: $150,000
- EBIT: $1,200,000
The next stage of the calculation is to add the non-cash values of depreciation and amortization (if any).
- EBIT: $1,200,000
- Depreciation: $50,000
- Amortization: $0
- EBITDA: $1,250,000
SDE: Another commonly used tactic for calculating business valuations is SDE, or the Seller’s Discretionary Earnings. This figure is calculated by adding the owner’s salary back into the final EBITDA number. This number is particularly important to prospective buyers, as they would like to set expectations for their take-home pay following an acquisition. For smaller businesses, it’s common for owners to take an active role in daily operations, often working IN the business.
The main difference between SDE and EBITDA is that the seller’s discretionary earnings include the owner’s annual salary. In a small to mid-sized business, it’s common for an owner’s salary and discretionary spending, or perks, to become mixed up in the daily outgoings and the bottom line of a business. SDE blends the profits and owner compensation into one number to normalize earnings.
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After everything that you’ve read, it should be clear that valuing a business is a complex process! There are several methods for creating a valuation, but not every one of these will be the right choice for every situation. Determining value means pulling information from cash flows, net income and operational standings.
Jason Brice is an experienced broker specializing in the sale of businesses whose values range from $1,000,000 to $15 million. For businesses of this size, the industry standard for determining market value utilizes EBITDA (and sometimes SDE). The benefits of using these methods are to create a clear, uniform comparison between businesses.
Before taking your business to market, consult a professional to be your guide through this complex process and ensure that your business is set to achieve the highest valuation and the best terms of sale possible.
