A company’s job is to provide a service in exchange for money. This income of money into a business—is its cash flow—is the lynchpin on which a company turns. The amount of money that flows into and out of your business not only allows it to grow but to provide a gateway to more funding by showing the profitability of your business to investors. And if you want to sell your business (or buy someone else’s), having this data is vital to making the sale.
Tracking this positive cash flow isn’t as easy as taking one column and subtracting it from another. Your business—any business—has many different inflows and outflows of cash, along with amortized debt, depreciation of assets, and more. As such, there are multiple ways to track these earnings by using accounting financial metrics. Below are two of the more commonly used tools for tracking a company’s profitability—either for internal use, current and potential investors, or for selling a company. Finding the right one will help you to do all three.
Seller’s Discretionary Earnings (SDE)
Ideal for small companies, SDE (also known as SDCF, or Seller’s Discretionary Cash Flow) works well when the owner is also the manager. Because of this owner-operator situation, it becomes difficult to separate the earnings of the owner vs. that of the company. Since these two earnings are so inextricably linked, instead both values are kept together, the owner’s total compensation added back into the value as an “addback.” A typical SDE is calculated as follows:
- Start with the business’s pretax earnings.
- Add non-operating expenses, subtract non-operating income.
- Add one-time/atypical expenses, subtract non-reoccurring income.
- Add in depreciation and amortization.
- Add interest expense, subtract interest income.
- Add the owner’s total compensation.
Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)
EBITDA comes out of the 1980s with leveraged buyouts, and then saw popularity within assets-heavy industries where companies have to devalue them over long periods of time. Now it’s commonly used by many companies—especially within the tech sector—to evaluate profitability. Unlike some financial metrics, this doesn’t track the actual cash flow, just the profitability, and provides a lot of leeway for companies to put in or leave out certain things at their discretion. The basic formula is summed up by the name:
EBITDA = Revenue minus Expenses (this value excludes interest, taxes, depreciation, and amortization).
Another way of thinking about EBITDA is it’s essentially net income with the interest, taxes, depreciation, and amortization added back into it. Because this financial metric removes financing and accounting decisions, it’s a useful to analyze and compare profitability between companies and industries. However, it’s important to note that EBITDA should often be coupled with an additional financial metric focused specifically on tracking cash flow as EBITDA also makes an allowance for capital expenditures and management salaries.
Understanding these financial metrics allows you to show of your company’s cash flow and profitability, and to better compare acquisitions and current assets. If you’re interested in learning more about these financial metrics, or looking at full valuations for your company, contact George and Company. We have years of experience with the financial science behind these metrics and valuations, and will put them to work for you.