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EBITDA: 4 reasons it’s a flawed measure of profit and value

August 30, 2013 -  By
Jeffrey Scott

Jeffrey Scott

Are you looking to raise the value of your firm and sell it one day? There are many factors that determine the value of your business. Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is one important indicator that is often touted as a silver bullet –but taken on its own, it can be misleading and even dangerous.

EBITDA is a profit calculation made famous in the ’80s by leverage buyout firms. The firms would borrow money to buy a company then suck the money out of that company to pay off the loan. The calculation shows whether the purchased company can generate enough money to cover the loan repayments. Yet, EBITDA is a flawed indicator. It masks some important elements in running and building a successful business.

Flaw No. 1: EBITDA ignores working capital (cash) to run the business

Your EBITDA calculation may show a high profit, but your company may be the type that requires a lot of cash to run operations, such as to finance maintenance contracts, float municipal clients, pre-buy materials and buy equipment.

Track Return on Assets (ROA). It calculates the ratio of net profits divided by the amount of total assets needed to run the business, such as equipment and cash. The higher the ratio, the lesser assets and money are required to run your business, making your business a more lucrative investment.

It is important to manage ROA as you grow your business. Otherwise, your growth will cost too much cash, in which case you will grow too slowly or go hungry trying.

Flaw No. 2:  EBITDA overstates value in equipment-heavy companies

If you are not making enough money to cover future equipment purchases, then you are leaving yourself in a hole. You may be earning good money, but not enough to eventually replace the broken down backhoe or bucket truck sitting in your yard. It is critical to track the cost of equipment replacement as a real cost, and track your net profit after planned depreciation. This is especially true for businesses that have significant equipment expenses.

Flaw No. 3: EBITDA can be increased by reducing management and sales staff

EBITDA can be misleading because you can profit by firing employees and removing your management layer.  For companies on the cusp of growth, owners can make more money if they keep the overhead minimized and do as much of the sales and management as possible. Radically reducing overhead can measurably raise EBITDA, but it also means that you have not created a “company for sale.” Rather you have created a job that makes you a lot of money.

You have to find the right balance.

Get clear on your objectives. It is important to develop sales and management people in your firm if you ever want to sell or exit from the day-to-day functions of your business.

Flaw No. 4: EBITDA can be at odds with net-to-owner

A business is not a business if it doesn’t make excess money for the owner to cover the inherent risk. You can manipulate EBITDA upward by reducing the net-to-owner. In other words, if you reduce your perks, land investments, business write-offs and pay, you can make EBITDA look strong. But is that really in your best interest?

A smart buyer will use an “adjusted EBITDA” calculation to take this into consideration.

As long as the potential buyer can clearly track and calculate the net-to-owner, then, as an owner, you should not give up your own salary as you focus on growing your business and the value of your nest egg. It is not either/or, rather it is both/and.

This is especially true for design/build companies that should be making a very healthy net-to-owner year over year, since their valuation can be much lower.

The caveat: Sometimes it is better to not take the perks and let it fall to the bottom line—there is an important balance you need to strike when thinking about selling.

Summary

Get clear on your objectives and identify the proper dashboard measurements you should be tracking. Don’t focus on just one silver bullet. Find the right balance between overhead and net-to-owner.  Focus on reducing working capital needed while making most efficient use of your equipment and related assets. Formeost, enjoy your business and your life. You CAN do both.

Scott, a consultant, grew his landscape company into a very successful $10 million enterprise, and he’s now devoted to helping others achieve profound success. He facilitates The Leader’s Edge peer group for landscape business owners who want to transform and grow their business. His members achieved 27 percent profit increases in their first year. He has a master’s degree in business administration. To learn more, visit www.GetTheLeadersEdge.com.

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About the Author:

Jeffrey Scott, MBA, author, specializes in growth and profit maximization in the Green Industry. His expertise is rooted in his personal success, growing his own company into a $10 million enterprise. Now, he facilitates the Leader’s Edge peer group for landscape business owners—members achieve a 27 percent profit increase in their first year. To learn more visit www.GetTheLeadersEdge.com.

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