Understanding Profitability & EBITDA
“How profitable is the business?” Though a simple question, it is one with critical implications. While most software founders and executives have some understanding of their company’s profitability, many of our clients are generating more profit than suspected. Accurately understanding earnings is paramount in communications with shareholders, team members, and potential investors, especially when considering a transaction. Knowing what to look for can be the difference between losing money and generating a profit, which has real dollar implications.
First, we will define profitability as EBITDA, or earnings before interest, corporate taxes, depreciation, and amortization. EBITDA is a measure of a company’s earnings and is used in conjunction with revenue, cost of goods sold/gross profit margin (see more about calculating COGS here), and net income to assess a company’s overall financial performance.
To calculate EBITDA, simply take the net income of the business and add the following:
- Interest Expense
- Depreciation Expense
- Amortization Expense
Easy, right? Now, here’s where it gets interesting. There are additional expenses that can be considered when analyzing profitability. These are referred to as EBITDA Adjustments (also known as Add-Backs).
EBITDA Add-Backs are expenses not expected to be part of the business going forward or are not typical expenses historically. These can include any one-time, non-recurring expenses, as well as expenses that would no longer be incurred if the business were acquired. These include, but are not limited to:
- Non-recurring legal expenses
- Non-recurring labor expenses (recruiting, severance)
- One-time project expenses (web redesign, system rewrite)
- Personal/lifestyle expenses incurred by owners/executives
- Above market compensation for executives (market rate is considered $200-300K per year, any compensation above is added back)
- Profit sharing expenses for employees not expected to continue with the business
- Engineering and development expenses on new product that has generated little to no revenue
Company A has $5 million of revenue with $5.5 million in total expenses, which results in net income of ($500,000). They have $500K total in interest expenses, depreciation, and amortization. This results in an EBITDA of $0, which translates to an EBITDA margin of 0% (($0/$5 million), indicating a breakeven business. In addition, there are the following expenses:
- $1.5 million in compensation going to three key owner-operators
- $300k recruiting expense to hire a new head of marketing and head of sales
- $50k one-time web redesign expense
If we assume that, in a scenario where the business is acquired, the three key owner operators will exit and it is determined they need to be replaced at salaries of $250K each, then EBITDA is adjusted by:
- Adding back $750K of above market compensation
- Adding back $300K recruiting expense
- Adding back $50K one-time web redesign expense
Total Add-Backs: $1.1 Million
Adjusted EBITDA (EBITDA + Add-Back Amount): $1.1 Million (22% EBITDA margin)
By analyzing the company’s expenses and determining the appropriate add-backs, it is shown that the adjusted EBITDA is $1.1M (22% EBITDA margin) as opposed to $0 (0% EBITDA margin). This represents a significant increase in profitability over the original breakeven EBITDA, and greatly alters the way the financial performance of the business can be presented.
If you have any questions about calculating EBITDA and add-backs, please don’t hesitate to reach out.
By Austin Hammer, Analyst