Over the past few weeks, I have had the pleasure of delivering several customized leadership development programs with a focus on Business Acumen to participants in the Agricultural, Commodity Chemicals, Pharmaceuticals, and Information Technology industries. Many of the organizations Advantexe works with have realized in our complex and global business world, having solid business and financial acumen skills is now more than a nice skill set to have; it is an absolutely necessity.
While all of the industries I have been working with over the past few weeks are different and unique, they all have similarities that are brought together under the umbrella of Business Acumen. Each industry I mentioned is comprised of organizations with different business strategies and financial management metrics that keep score of their strategies. The similar financial statements that track their performance include the Profit and Loss statement, the Balance Sheet, and the Cash Flow report. These reports are also supported by a number of specific metrics including Return on Sales (ROS), Return on Assets (ROA), and Return on Equity (ROE).
One of the most popular metrics of financial performance is called “EBITDA” and it is an as important financial acumen skill today as it ever has been. EBITDA stands for Earnings before Interest, Taxes, Depreciation, and Amortization. In practical terms for non-financial people, EBITDA is a metric that measures the profit of your business (and that could mean a business unit, region, district, or any other business entity) before reducing that profit by subtracting out the interest expense for debt, the taxes paid to federal, state, and local governments, the wear and tear of equipment, and the acknowledgment of the costs associated with overpaying for an asset or another business.
In other words, EBITDA provides a metric of the profit of the “controllables” of your business! If you are a leader and being held accountable for your performance, you want the measurement of your performance to be controlled by you. Interest is what an organization pays for debt. If you are running a profitable business, but your company takes on debt to invest in another part of the business, is it fair for you to be penalized by the debt decision if it has nothing to do with you and your business? The answer is no! You want to be held accountable for the things that you control.
The other benefit of utilizing an EBITDA approach to measure performance and planning in your business is the relationship to cash flow. Depreciation and Amortization are non-cash events and in addition to being out of your control, the cash implications are also out of your control. Without having to worry about those expenses – which only can serve to reduce profitability – you can focus on driving the real profit of the business which includes generating revenue less the cost of goods sold and less the operating expenses of doing business.
Valuing a Business
In addition to being a very practical measurement tool to gauge the effectiveness of leaders, there is another very important function of EBITDA and that is helping to value a business. Generally, a business can be valued by a multiple of EBITDA. Depending on the industry, the intensity of capital investment required in equipment, and barriers of entry, the EBITDA multiple is typically between 5-10x. For example, a business with an EBITDA of $100 million could be worth at least $500 million to acquire at a 5x EBITDA multiple. That means the greater the EBITDA, the more valuable the company.
There are some Issues
While there are many positive and great aspects to EBITDA as a financial metric, it does have some detractors. One of the issues that some find hard to deal with is if a company is in a capital intensive industry requiring constant and significant investments in plant, property, and equipment. By not taking investments (interest) and depreciation into account, capital intensive organizations may be valued less in terms of the EBITDA multiple factor. If you are working hard, building a profitable business, and carefully managing your asset utilization, it could be very frustrating to be involved with a business that doesn’t have a lot of financial value because of the “definition of a financial metric.”
In summary, Business Acumen and subsequently financial management skills are an entry ticket to success. Understanding metrics of performance, their drivers, and what you can do to improve them is very important for your business and career.