Accountants use the net profit and add back certain expenses to determine EBITDA. There are some tricks and nuances to calculating the number. In addition the earnings is also adjusted for certain benefits paid to owners for smaller business operations. This article explains how EBITDA is derived and how to find those expenses that should be excluded which adjusts EBITDA. This article will first explain the standard formula for EBITDA and the effect each of the adjustments of interest, taxes, depreciation and amortization have on EBITDA. There are two more follow-up articles related to this subject covering a detailed case study and addressing the drawbacks of the formula. Be sure to read both in order to have a comprehensive understanding of EBITDA.
Standard Formula for EBITDA
In order to appreciate the formula the reader should first review a simple profit and loss statement (income statement) for the purpose of being reminded of important points along its structure that are instrumental with the formula.
White Diamond Marine Inc.
For the Year Ending December 31, 2015
Marina Fees 64,402
Total Revenues 1,170,701
Cost of Sales/Service/Marina:
Sub-Total Costs 887,929
Gross Profit 282,772
Office Operations 27,200
Taxes and Licenses 21,303
Sub-Total Expenses 193,370
Operational Profit 89,402
Sub-Total Capital Costs 34,314
Net Profit $31,686
At first glance this income statement (profit and loss statement) appears straight forward. Based on the presentation format it would appear earnings before interest, taxes, depreciation and amortization is the operational profit value. All of the items affecting earnings are after operational profit.
This is when accountants ask questions. Nothing is as it first appears.
Let’s first start in the revenue section. See the line identified as ‘Other’ revenue? Often small businesses include interest earned on short term loans and bank interest in other income. It turns out this business earned $1,310 of interest holding the debt for a used boat during the year. Let’s look at the ‘Interest’ adjustment associated with EBITDA.
An accountant will want to know how the boat costs are derived. Often in dealership accounting, floor plans are used to finance cars and big ticket items. Boats fall into this category. This dealership includes the cost of interest paid on the floor plan into the cost formula. There were 32 deals for a total of $31,204 of interest paid. In a traditional retail operation inventory is financed via vendor accounts therefore there is no interest expense on the income statement. However, with big ticket items interest is generally a result of using outside financing to carry the inventory for extended periods of time. But under normal business financing options interest isn’t used to finance inventory. Therefore the interest included in the cost of sales is added back to the earnings to neutralize the effect it has on the reported amount. EBITDA is adjusted as follows:
EBITDA Without Adjustments: $89,402
Less Interest Earned on Short Term Note (1,310)
Add Back Interest Paid on Floor Plan Included in
Costs of Boats Sold 31,204
EBITDA With Interest Adjusted $119,296
Several readers are probably still scratching their head in regard to the floor plan interest. Think of the floor plan loan as a working capital loan from a bank whereby each monthly payment is allocated as a cost of carrying that particular boat in the inventory. It this interest were transferred to the ‘Interest’ line under capital costs, cost of sales would be $31,204 lower and operational profit would be $31,204 higher.
I have reviewed over 200 different sets of books among 100 different types of businesses and I never saw taxes handled the same way twice. There are two problems with taxes, the first is a loose interpretation of the term and the second problem is the accounting process.
Let’s first address the term and the best way to interpret taxes with respect to EBITDA.
Here is a list of the various taxes:
- Federal Income Tax
- State Income Tax
- Local Income Tax
- Personal Property Tax
- Real Estate Tax
- Revenue Tax
- Franchise Tax
- Transfer Tax
- Employment Taxes (Social Security/Medicare)
- Recycling/Tire/Usage Tax
This is a list of taxes most small businesses pay to operate. This doesn’t include the traditional trustee taxes such as sales and meal taxes collected by a business for the benefit of the state or local government. Furthermore, there are other taxes included in traditional bills such as the 911 tax on the cellular bill.
Therefore, the question at hand is what does the word tax mean in the EBITDA acronym?
If you look at the tax list above there are two inherent forms of tax. First are those tied to a form of basis that changes very little from year to year. Personal property and real estate taxes are perfect examples of this formula. The local county values these two assets and may change their value a little from year to year. But in general this basis remains relatively flat from year to year. The same is true for payroll taxes. This form of taxation is across the board for all entities and is tied to payroll. Some of the taxes are flat fees like the franchise tax or the recycling tax.
However the tax tied to overall performance of the business is the ‘T’ in EBITDA. These are your income taxes and transfer taxes. These taxes are controllable based on exterior circumstances and therefore excluded.
THOSE TAXES THAT ARE FLAT OR TIED TO A FIXED ASSET BASIS AND PAYROLL TAXES ARE NOT EXCLUDED IN DETERMINING EARNINGS. INCOME AND TRANSFER TAXES ARE EXCLUDED IN CALCULATING EARNINGS.
This raises the question about revenue taxes.
Revenue taxes are a very similar to income taxes and are a very small percentage of the revenue a business reports; the tax is assessed by local governments for a business license. In general they are mandatory and there is no method or offset as with income taxes to reduce the tax. Therefore they indeed are included in determining earnings.
Now let’s shift the focus to how the taxes are recorded. Improper accounting can change the EBITDA value significantly. To illustrate, go back to the income statement and look at the taxes and licenses line. After pulling the detail ledgers, this is the report’s results:
Taxes & Licenses:
State Franchise Tax $250
State Securities Fee 50
Marine Dealers License 500
Marine Dealer Tags 380
Local License 1,842
MD Revenue Income Tax (2014) 10,233
Annapolis Property Tax 714
Real Estate Tax (County) 5,040
Coast Guard Levy 741
IRS Penalty 1,250
Extension Payment (2014) 303
Total Taxes and Licenses $21,303
Look closely at the details. Notice the $10,233 for 2014 taxes? The bookkeeper records the actual final tax as reported on the state return as an expense in taxes and licenses. It turns out that the income taxes at the bottom of the report is the estimated amount for 2015. The state income taxes covers two years in the report. Furthermore White Diamond Marine paid $303 for the 2014 extension of the return to the IRS. This should be excluded too. Now review the EBITDA through the letter ‘T’.
EBITDA Adjusted for Interest $119,296
Add Back MD Income Tax for 2014 10,233
Add Back IRS Extension Payment 303
EBITDA Adjusted Through the Letter ‘T’ $129,832
For readers not familiar with depreciation, it is encouraged that you to read the following articles:
Depreciation is a methodical allocation of a capital investment in tangible assets or real estate (land is excluded). Since a capital investment is a function of financing via debt or equity it is excluded as an operational expense in the earnings calculation.
Most businesses generate a single line for depreciation on the income statement. However, sometimes management separates depreciation into that which is general in business operations and the amount utilized by the respective profit centers.
Go back and look at White Diamond’s revenue and cost of sales section. Notice the three distinct profit centers? They are:
- Sale of Boats – Consisting of one line of revenue and the inventory costs of those boats including floor plan interest. Commissions paid to salesmen is a function of labor costs.
- Service Department – Service fees and the costs include labor and parts.
- Marina Fees – Marina fees consist of two sources, one is rental income also known as slip fees and extraction/insertion fees (lifting and setting of boats out/in the water using a heavy lift crane, boat crane system). The costs associated with this piece of equipment is included in the equipment line and there are repair costs to maintain the docks. White Diamond Marine depreciates the boat crane as a cost to that work center. Of the $22,602 of equipment costs, $9,457 is depreciation.
This is an example of a functional income statement and not the traditional presentation format. This $9,457 of depreciation is an expense included in the original stated operational profit. Continuing with the adjustment schedule:
EBITDA Adjusted for Interest/Taxes: $129,832
Depreciation Adjustment 9,457
EBITDA Adjusted for Interest/Taxes/Depreciation: $139,289
Amortization is similar to depreciation except the expense allocation is for intangible assets. These include financial costs, organizational costs, training and some legal work. With White Diamond Marine they fully exclude amortization expense from the determining operational profit and presented this information in the capital costs section.
Be careful though, similar to depreciation some businesses will allocate out amortization to cost of sales. The prudent step as a seller is to identify this. As a buyer, you may not want to ask.
Summary – EBITDA
The following is a schedule illustrating all the adjustments to the original operating profit.
Operating Profit $89,402
Less Interest Revenue (1,310)
Add Interest Expense in COS-Boats 31,204
Add MD Income Tax 2014 Paid 10,233
Add Extension Payment to IRS 303
Add Equipment Depreciation 9,457
This is almost a $50,000 difference over the initial operational profit as reported. If this Marina were for sale and the multiplier is a three (under the Discretionary Income Method of Valuation), the negotiated price between the two values is $150,000 ($50,000 * 3).
So any businessperson wants to adjust operational profit to the correct EBITDA; it is important to understand the formula and how EBITDA is calculated. More importantly, sophisticated entrepreneurs realize that small businesses do not follow strict rules or universally accepted standards (GAAP) to report income. A reader of information must ask questions to gain a high level of confidence that the derived EBITDA is accurate. Act on Knowledge.