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BUSINESS VALUATION

Musings on business value, sale preparation, sale negotiations, sale structure.

You cannot do this

As a child I always struggled with understanding the concept of “you cannot have your cake and eat it”. It seemed to me that if you ate your cake, you still had it (in your tummy). My father pointed out that then “I had, had it”. My ever practical German mother muttered that I would have only had it for a few hours anyway.

A pivotal point in the valuation of small businesses involves calculating a figure called EBITDA – Earnings before interest, tax, depreciation and amortisation. For lack of a better description, it is what small business okes think of as their net cash flow or free cash. Look at your income statement. Near the bottom you will find something called Net Profit Before Tax. Sometimes it appears before interest is deducted as an expense, and then it is called Operating Profit.

Onto that number, add back any interest, finance costs and depreciation allowances which are listed in the general fixed expenses, and which have already been deducted. That number is referred to as the EBITDA. Sometimes personal expenses in the business which can be proved to be as such are also added on. That we call the EBITDAD. The extra D stands for “drawings”. Both EBITDA and EBITDAD constitute a well used basis against which a range of multipliers can be applied.

But valuations involve more than multiplying two numbers together. The balance sheet also plays its part. So as one depreciates the value of assets by way of taking off this expense in the income statement, so the asset base (property and equipment) is… well, depreciated. In conjunction with EBITDA(D) calculations, the depreciated value of assets has to be used to determine a fair value.

What you cannot do, is add back the depreciation in the EBITDA, and then use new or market values of the equipment in arriving at a business value.

That’s like having your cake and eating it. Except SARS will want a slice as well. If you insist on doing it, it really is a bit like what is left a few hours after having had one’s cake! Except you may be in it.

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2 Responses

  1. Gail Richards says:

    How does one calculate a selling price for a small but active and profitable business that the working owner wants to sell (service industry) – to arrive at a fair selling price (neither to undersell or chase potential buyers away). Should the EBITDA calculation be used and then what?

    • Mark Corke says:

      Valuing a business is a complicated issue which is different for every enterprise. There is an entire industry dedicated to helping business owners to get a bead on reliable answers.
      It does not involve simply multiplying two numbers together, adding something to something else, and ignoring some accounting rules. But those things all help!
      Do yourself a favour, and get some professional help. It will be money well spent in targeting the right market league.