Why Numbers Matter: Net Income vs EBITDA
I had a great meeting the other day with one of our lenders. But no matter how well prepared I am and how many times I go over our balance sheet, there are always a few questions that throw me off guard. While the basics like net income and gross profit are always important, every lender, investor, banker or prospective buyer seems to focus on different metrics in order to determine the business value for their own purposes.
You may not have outside investors or business debt right now, but if you’re the owner of a growing business, chances are pretty good that one day you’ll need to discuss your financial statements with someone other than your accountant. And YOU, as the business owner, need to take ownership and understand the numbers.
Our business has doubled in size a couple of times now, and I’ve worked with banks as well as private lenders for funding. I have also sold a business, going through the process of business valuation followed by detailed discussions with prospective buyers.
I run sales and operational reports daily and know my key metrics inside out. For us that means not only cash flow and total sales but also rounds of golf, covers in the restaurant, and the number of bays booked on the driving range. For the magazine it was the number of ad pages sold per issue, revenue per page and editorial vs advertising page ratios. Monthly I reconcile accounts, review net income statements and balance sheets, analyze cash flow, and update projections.
Until recently I left what I viewed as the “more complicated” accounting and financial analysis until year-end, letting my CA deal with amortization and depreciation, making adjustments and letting me know if our bottom line met our projections. But I know that if I can stay on top of all those numbers monthly, if I can project not only cash flow but also free cash and EBITDA on a regular basis, then I can make better decisions throughout the year that will impact our overall business performance.
Net Income
Net income seems fairly straight forward, as it represents your total earnings. But even so, net income is also referred to as net profit or net earnings, which is slightly different than operating profit and very different than gross profit. So many terms and definitions can make your head spin!
Revenue = Total sales
Gross Profit (Gross Margin) = Revenue - COGS (Cost of Goods Sold, including labour costs)
EBITDA = Gross Profit - Operating Expenses
Operating Profit (EBIT) = Gross Profit - Operating Expenses - Depreciation and Amortization
Net Profit = Operating Profit - Interest and Taxes
Net Income = Net Profit = Earnings
EBITDA
More commonly we work from the other direction, taking the Net Profit and then adding back the interest, taxes, depreciation and amortization to get EBITDA:
EBITDA = Net profit + interest + taxes + depreciation + amortization.
EBITDA is one of the most widely used indicators of overall business value. The term seems simple enough, but the larger and more complicated your business, the less obvious and simple the calculation becomes.
Interest = interest on any short or long term debt, which can vary from one business to the next depending on the company’s credit rating, financing structure and location. Other types of interest, such as interest on accounts receivable for example, should not be included.
Taxes = corporate income taxes, which of course are hard to determine mid-year and can change based on jurisdiction. This does not include other taxes such as property, payroll or sales tax (gst, hst).
Depreciation reduces the value of any assets due to factors external to the business such as inflation and economic conditions. It is typically a year-end consideration. Notice that Capital Expenditures (CapEx) are not accounted for in any of these calculations.
Amortization = for tangible assets such as buildings and equipment, as well as intangible assets such as software and patents, the items are amortized over their useful life. Also typically a year-end consideration.
If you’re trying to get a feel for your EBITDA mid-year, the easiest way is to take the Net Income from your monthly income statement, and then add back in your interest on short & long term debt.
By using EBITDA to determine business value, it levels the playing field. Your company has some control over pricing, sales, costs of goods and payroll, but cannot control interest rates or inflation. One of the most widely used measures of a company’s financial health , it gives a clean picture of pure profitability and available cash flow. Financial institutions use EBITDA to monitor debt covenants, while investors use it to easily compare two companies in different locations with different financial arrangements. Apples to apples.
Yes, your metrics are important. Yes, your income statement is a great tool. Now go the extra mile each month to really analyze your performance so that you can feel confident about your year-end projections. And so that you can answer those questions without needing your CA to do it for you!