When analyzing a company for potential acquisition you may run into terms that are not familiar to you such as: Net Income, EBIT, EBITDA and SDCF. Having a thorough understanding of these terms and the relationship between them may be the difference between a good financial decision and a bad one.
Net Income – Net income is an accounting term used to define the bottom line of the income statement. It is an accounting concept calculated as follows: Revenue – Cost of Goods Sold – Operating Expenses = Net Income. Net Income is not the best indicator of a company’s true financial performance. Why? Because non-cash expenses such as depreciation and amortization are included in the operating expenses that are subtracted from revenue. Depreciation and amortization are theoretical expenses that represent the “using up” of a company’s fixed assets (those held on the balance sheet at cost). Since depreciation and amortization are non-cash expenses, including them in operating expenses and subtracting them from revenue will help reduce a company’s tax obligation but it will also understate the amount of cash available to a potential acquirer.
Net income is influenced not only by cost of goods sold, operating expenses and non-cash expenses but also expenses specific to current ownership such as interest expense. Since the current ownership may maintain a level of debt that is not optimal, but specific to their personal situations, interest expense must be stripped out of net income before a company’s financial performance can be properly evaluated. For example, consider a company that is “over-levered” (they have more debt on the books than the company can support and manage). This may have occurred simply because the owner has no additional cash or equity to contribute to the business. The company’s interest expense under this scenario will exceed that of an owner maintaining a lower level of debt. In order to evaluate the financial performance of the business, sans the financial situation of the current owner, a potential acquirer must strip out interest expenses and concentrate on expenses specific to the business.
Another expense which must be excluded from your acquisition analysis is taxes. If we were to evaluate a company’s net income, we would not only be incorrectly evaluating the effects of non-cash expenses on the business (depreciation and amortization) and the impact of the current ownership’s financial situation (interest expense) but also a tax effect that is based on a percentage of taxable income number that is already skewed by these expenses (depreciation, amortization and interest). Since we do not want to evaluate the company to include the current ownerships capital structure in our analysis (interest expense) and their discretionary expenses (to be discussed later) we must move above the tax effect on the income statement in order to completely strip out their effect (and the effect they have on the company’s income tax expense).
EBIT – is an abbreviation for Earnings Before Interest and Taxes. EBIT provides a better indication into the true financial performance of a company than net income for all the reasons specified above. EBIT is not skewed by the company’s tax calculation and the current owner’s capital structure. It is one of the best indications of actual operating profit. Unlike EBITDA (discussed in the next paragraph), EBIT incorporates in its calculation an annual expense allotment for the obsolescence of the company’s fixed assets used for revenue producing purposes. This expense takes the form of depreciation for fixed assets and amortization for intangible assets. EBIT is calculated as follows: Net Income + Interest Expense + Income Taxes = EBIT.
EBITDA – is an abbreviation for Earnings Before Interest, Taxes, Depreciation and Amortization. EBITDA is the best indicator of a company’s actual cash performance. It strips out the company’s tax effect, current ownership’s capital structure and eliminates the effect of non-cash expenses such as depreciation and amortization. Rarely does a better metric exist to evaluate the actual cash available to ownership at the end of an operating period to pay down debt, pay taxes and offer a return to investors than EBITDA. EBITDA is calculated as follows: EBIT + Depreciation + Amortization = EBITDA.
When evaluating small business acquisitions you will often encounter another acronym SDCF. SDCF is an abbreviation for Seller’s Discretionary Cash Flow. Seller’s Discretionary Cash Flow assumes that the owner of the business also works for the business and requires a salary for services performed. SDCF is calculated as follows: EBITDA + one owner’s salary = SDCF. It is important to recognize that SDCF is not the return you will realize for the risk you are taking as an owner or acquirer but rather the combined return for the duties you perform on a day to day basis (your salary or wages) and the return you require for the risk of being the owner. If SDCF is less than or equal to the salary you (or an employee) will require to perform the day-to-day job duties left vacant by the current owner, then you will not be receiving a return for your financial investment. Your return will be simply a salary to compensate you for the duties performed as an employee of the business.
We’ll talk more about these metrics and how they should be used and analyzed in our next post. But for now, get comfortable with the terms. You will see them often when evaluating businesses for potential acquisition. You must learn to speak the language before you can make a reasonably informed and educated buying decision.