Demystifying EBITDA and its Relationship to Valuation

In the world of finance and accounting, EBITDA is a term that frequently comes up in discussions, financial reports, and investment analyses. EBITDA is an acronym for "Earnings Before Interest, Taxes, Depreciation, and Amortization." While it is widely used and considered a key metric in evaluating a healthcare company's financial health, its significance, calculation method, and interpretation can sometimes be misunderstood by business professionals ready to sell their business. The primary significance of EBITDA in M&A is that it measures a company's ability to generate cash flow and in turn, presents a standardized metric for the buyer universe to assess and pursue an acquisition opportunity. In the following sections, you learn more about EBITDA, including its definition, significance, calculation, and use within valuing a company. 

What is EBITDA?

As mentioned above, EBITDA is an acronym for earnings before interest, taxes, depreciation, and amortization. It is a financial metric that serves as a proxy for the profits generated by a business. The reason it is referred to as a proxy is that it attempts to demonstrate normalized cashflow performance by “adding back” financial items like entries based on capital structures, tax policies that are not under the control of the business, like federal and state income taxes, and depreciation entries made per IRS rules and Generally Accepted Accounting Principles (GAAP). This creates a value that enables comparisons with other companies in the healthcare industry. 

• Earnings – your company's net income or profit, which is revenue minus expenses.
• Interest – the cost of borrowing through loans and debt instruments.
• Taxes – corporate taxes levied on taxable income.
• Depreciation - decrease in the value of tangible assets over time due to wear and tear, obsolescence, or usage.
• Amortization - gradual reduction of intangible assets' value over their useful life, such as patents, copyrights, and trademarks.

The formula for calculating EBITDA is relatively straightforward:

• EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization

However, in practice, EBITDA is often derived from a healthcare company's income statement, where it is calculated as follows:

• EBITDA = Operating Income + Depreciation + Amortization  

Operating income, or operating profit, is derived by subtracting operating expenses (such as wages, rent, and utilities) from gross profit. Either way, it is calculated to provide a clearer picture of a healthcare company's operational performance. EBITDA is one of the most significant financial metrics used in mergers and acquisitions. It is a popular valuation metric used by buyers or investors to determine the perceived value of a company before the acquisition. The core significance of EBITDA in healthcare M&A lies in its ability to provide a clear understanding of a company's earning potential and its ability to generate cash flow.

Why Should You Understand EBITDA Basics?

As a healthcare business owner, you know that the "bottom line" refers to net profit or operating profit, but that bottom line contains financial data irrelevant to determining the current market valuation. For example, depreciation and amortization entries in accounting records are driven by Generally Accepted Accounting Principles (GAAP) but do not reflect normalized business operations. 

EBITDA also shows whether your healthcare business generates free cash and how much free cash is generated on a sustainable basis to meet future debt. Businesses interested in an acquisition want to know if the seller's business is viable now and will continue to be into the future. What is the core business profitability?

You may be ready to sell and need guidance on the market value of your business or you have been approached by a potential buyer with an offer. One advantage of utilizing EBITDA as a core metric in deriving a company’s value valuation is that it can apply to every type of healthcare business, regardless of segment, and is a universally recognized valuation method across industries and sectors. 

The following are some more reasons investors are interested in EBITDA:

• Performance Measurement - EBITDA provides a clearer picture of a company's operational performance by excluding non-operating expenses like interest, taxes, depreciation, and amortization, which can vary significantly due to factors unrelated to core business activities.
• Comparability - EBITDA standardizes earnings by removing non-operating factors, making comparing companies operating in different tax jurisdictions or with varying capital structures easier.
• Valuation - EBITDA is frequently used in valuation metrics such as the price-to-EBITDA ratio (P/EBITDA ratio), particularly in industries where capital expenditures and depreciation significantly impact financial results.
• Cash Flow Proxy - While EBITDA does not represent cash flow, it serves as a proxy for cash flow from operations, helping assess a company's ability to generate cash internally. Utilizing EBITDA as a core valuation metric makes it easier for potential buyers to compare companies. Of course, EBITDA is not the only factor that will be assessed when an acquirer is conducting due diligence on your business. It is supplemented with other financial and non-financial information, but it is commonly recognized and used as a primary valuation metric.

How is EDITDA Used to Value Businesses?

• Simplified Valuation Metric - EBITDA is a simplified metric for valuing businesses, especially in industries like healthcare where capital expenditures and depreciation significantly impact financial results. Focusing on earnings before non-operating expenses provides a cleaner and more consistent measure of your company's earning potential.
• Comparable Analysis - EBITDA facilitates comparable analysis by allowing investors and analysts to compare the operating performance of different companies within the healthcare industry. Since EBITDA removes the impact of financing and accounting decisions, it enables a more apples-to-apples comparison of businesses regardless of their capital structure or tax situations.
• Price-to-EBITDA Ratio - One of the most common valuation methods utilizing EBITDA is the price-to-EBITDA ratio (P/EBITDA ratio). This ratio compares a company's market capitalization to its EBITDA, providing insight into how the market values its operating performance relative to its earnings. A lower P/EBITDA ratio may indicate that a healthcare company is undervalued compared to its earnings potential.
• Mergers and Acquisitions (M&A) - EBITDA is frequently used in M&A transactions as a valuation metric. Buyers estimate the value of a target company using EBITDA multiples, often applying healthcare industry-specific multiples to the target's EBITDA to arrive at a valuation. This method helps potential acquirers assess the target's earning potential and negotiate a fair purchase price.
• Debt Capacity Assessment - Lenders use EBITDA as a key metric when evaluating a company's debt capacity. Since EBITDA reflects your company's ability to generate operating income before accounting for interest and taxes, it provides insight into its ability to service debt obligations. Lenders may calculate your company's Debt/EBITDA ratio to assess its leverage and creditworthiness, with lower ratios indicating a healthier financial position.
• Investor Communication - EBITDA can also be used in investor communication to highlight a healthcare company's operational performance and financial health. By focusing on earnings before non-operating expenses, companies can present a clearer picture of their core business profitability to investors, potentially enhancing investor confidence and attracting capital.

What is Adjusted EBITDA?

The basic EBITDA definition can be expanded to include Adjusted EBITDA, also known as Adjusted Earnings Before Interest, Taxes, Depreciation, and Amortization, a modified version of the traditional EBITDA metric. While EBITDA aims to provide a clear picture of a company's operational performance by excluding certain non-operating expenses, adjusted EBITDA goes a step further by excluding specific one-time or non-recurring items that may distort the true underlying profitability of the business.

The goal is to generate an EBITDA that reflects the operating picture for anyone running the business. Most businesses have financial impacts that reflect the business owner's decisions that someone else might not have made.

Adjusted EBITDA typically starts with the EBITDA figure and then adjusts it by adding or subtracting certain items. Common adjustments may include:

• Non-recurring expenses - These are one-time costs that are not expected to occur again, such as restructuring charges, litigation settlements, or expenses related to mergers and acquisitions.
• Non-cash charges - Certain non-cash expenses, such as stock-based compensation or impairments, may be excluded from adjusted EBITDA as they do not impact the company's cash flow.
• Unusual gains or losses - Adjusted EBITDA may exclude gains or losses from the sale of assets or investments not considered part of the company's core operations.
• Other adjustments - Depending on the company and industry, other adjustments may be made to reflect the true operating performance, such as changes in accounting methods or the impact of significant events like natural disasters.

Adjusted EBITDA serves several purposes and is used in various financial analyses and decision-making processes:

• Valuation - Adjusted EBITDA provides a clearer picture of a company's normalized earnings, which can be useful in valuation models such as comparable company analysis or discounted cash flow analysis.
• Financial Reporting - Companies may use adjusted EBITDA in their financial reporting to provide investors and stakeholders with a more accurate view of their operating performance, especially if significant non-recurring or non-cash items could distort the reported earnings.
• Debt Covenants - Lenders may use adjusted EBITDA to assess a company's compliance with debt covenants or determine its borrowing capacity. By adjusting for one-time or non-recurring items, adjusted EBITDA provides a more reliable measure of the company's ability to service its debt obligations.
• Investor Communication - Adjusted EBITDA can be used in investor presentations or communications to highlight the company's underlying profitability and performance, mainly if items impact reported earnings but do not indicate the company's ongoing operations.

When preparing any healthcare company for sale, an experienced advisor must provide assistance and access to experienced third-party support in determining a company’s adjusted EBITDA, to best present an accurate picture of the company’s performance to the identified group of potential acquirers. While no standardized formula exists to determine a company’s value based on Adjusted EBITDA, an experienced advisor can provide relevant guidance and generate enough interest from the market to determine the current market value of your business based on supplied offers. The truest value of a business is what a buyer is willing to pay for it, and EBITDA is a key metric in the presentation of offers from the buyer community.

Contact M&A Healthcare Advisors when you are ready to sell your healthcare company or find an equity partner to grow your business. Our team is available to guide you toward reaching your M&A goals.