Cash Flow EBITDA And Other Terms That Affect Value

WHAT ARE THE CASH FLOWS OF THE BUSINESS?

This report highlights the first component of value, cash flow. What are the cash flows that the business generates? We will review both Discretionary After Tax Cash Flow and Earnings Before Interest Taxes Depreciation and Amortization (EBITDA).

WHY IS CASH FLOW IMPORTANT?

Cash is King this is noted as a saying in many instances, but in the case of business valuation there is no truer a statement. While financial statements are prepared according to generally accepted accounting principles to report earnings, it really is the adjustments to these earnings that results in cash flow it is cash flow that pays the interest on debt, covers taxes payable, bonuses to employees and owner compensation, makes investments in capital assets and facilitates the exploitation of growth opportunities. There are really two derivatives of earnings that correspond to cash flow that are used in valuing businesses.

DISCRETIONARY AFTER TAX CASH FLOW

The first is discretionary after tax cash flow. This is the cash that is generated in the business that is available for either distribution to the shareholders or to invest in further growth opportunities for the business. It is discretionary because the business owner can do with it what she wishes without jeopardizing the performance of the business as it stands. It is discretionary because it is the cash that is generated after paying the debt servicing costs, the income tax owed in the year, employee bonuses, and ultimately creates the return on the invested equity capital in the business. Discretionary after tax cash flow is the pure form of cash flow a business generates and is fundamentally the best cash flow stream to use when valuing a business. The second form of cash flow that is more commonly used in valuations is EBITDA

WHAT IS EBITDA?
Arthur walked into Cathys office on a Monday morning with a confused look on his face Cathy why are all my friends that are fellow business owners always talking about EBITDA, what happened to good, oldfashioned Net Income? Arthur Cathy replied as you know everything is a shortcut these days. There is absolutely nothing wrong with Net Income, in fact that is what I focus on for the measurement of our business success along with discretionary cash flow, but EBITDA is being used and referred to more and more, just because it is easily used to compare somewhat similar, but not identical businesses EBITDA is a term used so much we often wonder whether people in general really know what it is beyond what the letters stand for. It is generally understood that EBITDA is Earnings Before Interest Taxes Depreciation and Amortization, but in reality, it is a short form approximation of cash flow that allows different businesses to be compared and analyzed in a consistent manner. EBITDA is used as a tool to standardize financial results in such a way that removes the business decisions of the existing corporate management with respect to the capital structure, the impact of tax, the nature and

Cash Flow EBITDA And Other Terms That Affect Value

age of the capital assets in the business and the depreciation policies of the business. What is left when all these items are added back is an adjusted earnings number that reflects the amount that would be available to all stakeholders in the business the shareholders, the bankers and the government.

IS THERE A PROBLEM WITH IT?

EBITDA does have its limitations. These limitations include the fact that there is no allowance for ongoing capital expenditure requirements. In Warren Buffets 2000 letter to shareholders, he refers to management that mention only EBITDA instead of Net Income, References to EBITDA make us shudder - does management think that the tooth fairy pays for capital expenditures?. At risk of trying to paraphrase a legend, what Buffet is saying is that by overlooking the depreciation expense (or capital expenditure requirements) a business (or acquirer) is at risk of making faulty decisions. While EBITDA is used as a tool to compare similar businesses, in isolation it only tells part of the story. EBITDA margin (% EBITDA compared to Revenue) of two similar businesses shows the quality of one company to the other. The table below illustrates the impact of two similar businesses with dramatically different operating results. Both businesses have $4.5 million in EBITDA, all other things being equal Zenith Manufacturing has better EBITDA margins.

Company 1

Zenith Manufacturing

Revenue Net Income add: Income taxes add: interest on long term debt add: depreciation and amortization EBITDA EBITDA margin

$11,500,000 $810,000 $202,500 $46,000 $25,000

$9,000,000 $810,000 $202,500 $46,000 $25,000 $1,083,500 12%

b b/a

$1,083,500 9%

Clearly while both companies have the same EBITDA, Zenith Manufacturing with higher EBITDA margins has higher quality earnings, would be better able to weather more severe business storms and would be able to reinvest more back into the business to capitalize on growth opportunities. Is EBITDA growing, steady or declining? The trends in any business are more important that any one year. When a business is analyzed, the past several years results are considered to determine the level of sustainable EBITDA of the business. If EBITDA is steadily increasing, as a result of investment in capital assets and general expansion of the business, then this represents a positive EBITDA trend. On the other hand if a business has erratic EBITDA results over the last few years and in the most recent year posts its best ever results, the level of sustainable EBITDA would be questioned.

WHY IS EBITDA USED?

EBITDA is used to make the business valuation process simpler for acquirers of businesses when they get a first look at a new opportunity. Though when the time comes to make a detailed assessment or valuation of the business, usually the items excluded in calculating EBITDA are reconsidered and diligently scrutinized.

Cash Flow EBITDA And Other Terms That Affect Value

WHAT IT ALL MEANS?

What this means is that for a business owner it may be important to know what their EBITDA is, but it is much more important to focus on: 1. ensuring EBITDA growth trends are positive and stable, 2. EBITDA margins are improving 3. that the components that are used to calculate EBITDA (depreciation, interest and taxes) are managed in a prudent manner, and 4. capital expenditures are made in such a way that produces sustainable growth in the business.

ABOUT EQUICAPITA
Equicapita is a private equity fund that acquires established, private, small and medium sized enterprises (SMEs) located primarily in Western Canada. Equicapitas investment drivers are to acquire operating companies at attractive valuations, with a history of generating sustainable cash flow and proven management teams. Equicapita believes that there is: - a generational opportunity to acquire baby boomer SMEs; and - a funding gap in the $2 to $20 million enterprise value range. The retirement of baby boomer business owners has been described as triggering one of the biggest transfers of corporate assets on record in Canada. This creates an environment with an abundance of opportunities to acquire SMEs with long-term operating histories, at attractive cash flow multiples. Equicapita provides investors with access to this alternative asset class via an efficient RRSP eligible structure.

DISCLAIMER
The information, opinions, estimates, projections and other materials contained herein are provided as of the date hereof and are subject to change without notice. Some of the information, opinions, estimates, projections and other materials contained herein have been obtained from numerous sources and Equicapita and its affiliates make every effort to ensure that the contents hereof have been compiled or derived from sources believed to be reliable and to contain information and opinions which are accurate and complete. However, neither Equicapita nor its affiliates have independently verified or make any representation or warranty, express or implied, in respect thereof, take no responsibility for any errors and omissions which maybe contained herein or accept any liability whatsoever for any loss arising from any use of or reliance on the information, opinions, estimates, projections and other materials contained herein whether relied upon by the recipient or user or any other third party (including, without limitation, any customer of the recipient or user). Information may be available to Equicapita and/or its affiliates that is not reflected herein. The information, opinions, estimates, projections and other materials contained herein are not to be construed as an offer to sell, a solicitation for or an offer to buy, any products or services referenced herein (including, without limitation, any commodities, securities or other financial instruments), nor shall such information, opinions, estimates, projections and other materials be considered as investment advice or as a recommendation to enter into any transaction. Additional information is available by contacting Equicapita or its relevant affiliate directly.

Cash Flow EBITDA And Other Terms That Affect Value