A Guide to EBITDA from RAS Recruitment Agency Sales
Introduction
When looking at a business’s financial health, especially for small businesses or law firms, one key number to check is EBITDA – which stands for Earnings Before Interest, Taxes, Depreciation, and Amortisation. This number helps measure how profitable a business is before extra costs (e.g. taxes or loan payments) get added in.
It tends to be used in a wide range of industries for the purposes of valuation, and very often a multiple is applied to it – eg 1.5 x EBITDA or 6 x EBITDA.
In this guide, we’ll cover:
- What EBITDA is and why it’s important.
- How to calculate EBITDA in simple steps.
- Where to find the numbers needed to calculate EBITDA for small businesses and law firms.
By the end, you’ll understand how EBITDA works and why businesses use it to measure success and value.
What is EBITDA?
EBITDA is a way to measure how much money a business makes from its core operations before factoring in certain costs. It helps show the true profitability of a company without aspects such as loan payments, taxes, or accounting adjustments getting in the way. This helps compare different businesses more fairly and show how much money they’re really making.
Breaking Down EBITDA
- Earnings – Profit the company makes.
- Before Interest – Ignores loan or debt payments.
- Taxes – Doesn’t include income taxes.
- Depreciation – Leaves out the loss of value in physical things such as buildings and equipment.
- Amortisation – Leaves out the loss of value in non-physical things such as patents or trademarks.
EBITDA is helpful for comparing businesses that have different taxes or loans. For example, two companies might run just as well, but one may have more debt. By looking at EBITDA, you can see how profitable they really are without letting taxes or loans affect the comparison.
Why is EBITDA Important?
EBITDA is useful because it gives a clearer view of a business’s performance by ignoring things that can vary from company to company, such as taxes or loans.
- Easy Comparisons – Helps compare businesses fairly, even if they have different tax rates or debt. This is useful when checking out competitors or deciding whether to buy another business.[1]
- Focus on Operations – Shows how well a company’s main business is doing, without distractions. By leaving out extra costs such as loan payments, EBITDA focuses on how well a company makes money from its main activities. For example, it can show if a business earns enough from client work without being affected by debts or taxes.[2] [3]
For example – Two companies might make the same amount of money, but one has big loans to pay off while the other doesn’t. If you just look at their total profits, the one with more debt might seem less successful. EBITDA helps strip away those loan payments and other financial factors so you can see how well each firm is actually running its business.
- Business Valuation – Used to estimate a company’s worth, especially when it’s being sold or merged.
How is EBITDA calculated?
To calculate EBITDA, start with the company’s profit (net income) and add back costs such as loan payments (interest), taxes, and the loss of value in equipment (depreciation) or aspects such as patents (amortisation). This helps show how much money the business is making from its main operations. There are two common ways to calculate it:
EBITDA – Net income + Interest + Taxes + Depreciation + Amortisation
OR
EBITDA – Operating Profit + Depreciation + Amortisation.
Both methods give a clearer idea of a company’s true earnings.2 [4]
Example Calculation
Let’s say a small business reports a net income of £120,000. On top of that, it has £10,000 in interest expenses, £20,000 in taxes, £15,000 in depreciation, and £5,000 in amortisation. To calculate EBITDA, you add these amounts back to the net income
£120,000 + £10,000 + £20,000 + £15,000 + £5,000 = £170,000
So, the business’s EBITDA would be £170,000. This number shows how much the business earns from its main operations before considering costs such as loan payments or equipment losing value over time.[5]
Where to Find the Numbers for SME and Law Firm Valuation
To calculate EBITDA for small businesses, you need to gather specific financial information. The Profit and Loss Statement is a key document that shows net income, interest expenses and tax expenses. Another useful resource is the balance sheet notes, which include details about depreciation and amortisation.
Many businesses also rely on accounting software like QuickBooks or Xero, which can generate detailed reports with all the necessary numbers.3 [6]
Special Considerations for SMEs
Small businesses in the UK may find EBITDA tricky to calculate because their finances are simpler, but their costs can vary.
First, they need to make sure they include all assets such as office furniture or vehicles when accounting for depreciation.
Second, they should separate everyday business costs from loan interest payments, which are tied to business growth rather than daily operations.
Finally, one-off expenses such as legal fees or new equipment purchases should be adjusted so they don’t make the business seem more or less profitable than it really is.1 3
Special Considerations for Law Firms
Law firms work differently from other small businesses because they rely on billable hours and client retainers for income. When calculating EBITDA for a law firm, it’s important to separate different revenue sources, such as retainers, contingency fees, and billable hours. Client retainers are of a much higher value to a buyer than fees generated from a one-off client. Depreciation should include office items such as computers and furniture, while amortisation should account for intangible assets such as goodwill from mergers or purchased client lists.
Since law firms often operate as partnerships, partner drawings aren’t business expenses but rather profit distributions, so adjustments may be needed to reflect this properly.[7] Similarly, where there is a limited company scenario and the owners are withdrawing dividend, company car costs etc instead of salary, the equivalent cost of employing the owners is factored into the calculation and deducted from the EBITDA before applying any multiple.
How EBITDA is Used
EBITDA is a useful tool for businesses in different ways.
Business Valuation
When a business is being sold or merged, EBITDA helps determine its value. Buyers often offer a price based on a multiple of EBITDA depending on the industry. A higher EBITDA multiple means the business is seen as more valuable, usually because of strong profits or growth potential.7
Comparing Business Performance
EBITDA can help compare a business to others in the same industry. By looking at the EBITDA margin, businesses can see if they are operating efficiently compared to competitors.
Checking Financial Health
EBITDA helps track a company’s profitability over time without being affected by taxes or loan payments. This makes it easier to see if the business is growing and making money from its main operations.
In addition, lenders look at EBITDA to see how much cash a small business is making from its day-to-day operations. This helps them decide if the business can afford to pay back a loan.
Limitations of EBITDA
EBITDA is helpful, but it has some drawbacks:
- Ignores big expenses – it doesn’t include money spent on important aspects such as new equipment or building maintenance.
- Doesn’t Show Cash Flow – it doesn’t track when money comes in or goes out, which affects how much cash a business has.
- Can be misleading – some companies tweak their numbers to make EBITDA look better than it really is.[8]
For example – a small business might leave out regular costs like software subscriptions from their main expense list, making it look like they’re making more profit than they really are. This is quite difficult to do if you work solely from prepared accounts from external accountants (even if unaudited), but still something to look out for.
Even with these issues, EBITDA is still one of the most popular ways to measure business performance.
Conclusion
EBITDA is a keyway to measure how profitable a business is and how much it’s worth. It focuses only on the money a business makes from its main activities, ignoring aspects such as taxes and loan payments. For small businesses wanting to attract investors or sell, getting EBITDA right is important. Adjusting for one-time costs and using accounting software or expert advice can help ensure the numbers are accurate and show the business’s true earning potential. As business brokers, we can quite often work out the EBITDA figure, but we do very often ask our clients to confirm it with their accountants, who very often are the best source of expert advice to get the correct figure.
[1] The Significance of EBITDA in valuing your company. Friend&Grant: https://www.friendandgrant.co.uk/blog/the-significance-of-ebitda-in-valuing-your-company/
[2] How To Calculate EBITDA in 3 Steps (With Examples). Indeed.com: https://www.indeed.com/career-advice/career-development/how-to-calculate-ebitda
[3] A Guide to EBITDA for SMEs. Alderway Partnership Capital : https://www.alderway.com/post/a-guide-to-ebitda-for-smes#:~:text=This%20guide%20will%20explain%20why%20EBITDA%20for%20small,empowering%20exceptional%20entrepreneurs%20in%20often%20overlooked%20Backbone%20Sectors.
[4] Understanding EBITDA: a short guide for businesses. Developmentbank.wales: https://developmentbank.wales/resources/learning-hub/finance-and-accounting/understanding-ebitda-short-guide-businesses
[5] What is EBITDA? A brief guide for small businesses. British Business Bank: https://www.british-business-bank.co.uk/business-guidance/guidance-articles/finance/what-is-ebitda
[6] How to Calculate EBITDA in Xero. (n.d.). Expense on Demand: https://www.expenseondemand.com/blog-posts/how-to-calculate-ebitda-in-xero
[7] Valuation of Law Firms Acquira Heysine: https://cdnc.heyzine.com/files/uploaded/v2/b7ddfd4c124b151f1d42bad19798e0cc83d2828d.pdf
[8] EBITDA: Definition, Calculation Formulas, History, and Criticisms. Investopedia: https://www.investopedia.com/terms/e/ebitda.asp