Understanding Earnings: Profit, EBITDA, Adjusted EBITDA, Maintainable Earnings?

In the Q&A below, Daleen Engelbrecht explores some of the terminology and issues around earnings during this phase.

Q: What financials are normally presented in the CIM?

A: At this initial step, potential buyers will be interested in the last few years’ trading performance and, in particular, how the current year is going. If your business is undergoing a period of growth, your deal team may choose to include a forecast to the end of the current year and perhaps for the next year or two, but they will only choose to include this if there is a genuine and supportable forecast. Potential buyers will also expect to see a recent balance sheet to give an initial indication of the assets and liabilities.

Q: What is Adjusted EBITDA?

A: EBITDA is earnings (profit) before interest, tax, depreciation and amortisation. Let’s break this down a little further:

• Before interest – a buyer will expect any debt in the business to be eliminated as part of the deal structure. In essence, they will be buying a company free of any debt.
• Before tax – it’s simply a convention that private companies are valued based on their profits before tax, which takes out of the equation potential differences in the tax positions of the parties. Complications include accumulated tax losses, differential cross-border tax rates, etc.
• Before depreciation (and amortisation) – depreciation is an accounting adjustment and a non-cash item, and where this is not significant buyers are often prepared to ignore this. However, where depreciation is significant, such as in a capital-intensive business, a buyer may well add back depreciation but include a take-back for annual capex expenditure. Your deal team is experienced in dealing with this, as it can become both complex and subjective.
  
  

Q: Why do we mention ‘Earnings’ and not ‘Profit’?

A: Profit tends to refer to the specific numbers in the accounts of the business, whereas earnings tend to reflect a more general, and adjusted, view of the performance of the business. The term often used in the UK, which forms the basis of most offers, is Maintainable Earnings (ME). Think in terms of an assessment of what the business is making ‘now’. On most deals, your deal team and the buyer will look to agree on a number for ME that forms part of the buyer’s offer.

Q: Why is the ‘Maintainable Earnings’ (ME) number so important?

A: ME is generally seen as the return the buyer will make from the business itself, as it stands now, for their investment. Simply speaking, the higher the agreed ME number, the higher the overall valuation will be.

Q: What other adjustments are made to arrive at the ME number?

A: We will normally adjust profit/earnings to eliminate, or ‘add-back’, any one-off or non-recurring costs. Add-backs will include excessive owner costs and pension contributions, one-off accounting/advisory/legal costs (such as the fee paid to Benchmark International), restructuring costs etc. Down the line, a buyer will include what are referred to as ‘take-backs’, such as realistic owner/management costs, but we will not ordinarily include these in the CIM as this would be a matter for negotiation.

Q: Do buyers consider cash flow, too?

A: Yes, buyers will want to form an understanding of the underlying cash flow of the business. For most trade buyers, the assessment of Adjusted EBITDA, less capex, will be a good enough approximation, but in the case of financial buyers, the analysis will be much more detailed.

Q: Why are margin percentages important?

A: Margins provide a story of their own when looking at financial information, and are important for various reasons:

• Revenue growth margin - this metric indicates the company’s revenue growth over one year compared to the previous year. A positive growth trend signifies that the business is expanding its sales activities, which can potentially lead to increased profits, especially if operating costs are being well maintained.
• Gross profit margin - this measures how efficiently a company is producing and selling its goods. It highlights the profitability of core production activities before accounting for any operational costs. A higher gross profit margin suggests strong cost management and pricing strategies imposed.
• Adjusted EBITDA margin - this reflects the company's profitability as a percentage of revenue. A growing EBITDA margin indicates a business that is increasingly profitable. Higher EBITDA margins mean more profits are being generated from business operations, which typically attracts greater interest from investors.

Share This Post