EBITDA versus Discretionary Earnings
In business transactions, it's common to refer to EBITDA or discretionary earnings in evaluating a business. These two terms are intended to provide a prospective buyer an estimate of free cash flow of the business, but they are unique in what they represent.
Below is a description of what EBITDA and discretionary earnings include and the main difference between the two.
EBITDA is earnings before interest, tax, depreciation and amortization. It's basically a measure of a business operating performance removing the impact of financing decisions (interest), accounting decisions (depreciation and amortization) and the owner's tax profile.
The reported EBITDA is then adjusted to get to a normalized EBITDA by removing non-recurring revenue and expenses and making other necessary adjustments, such as removing discretionary and personal expenses not deemed necessary for the operation of the business. This is typically used for business sales of the lower middle market and larger businesses.
Similar to EBITDA, discretionary earnings starts with earnings before interest, tax, depreciation and amortization. It also requires making similar adjustments that you would make in adjusting EBITDA, such as removing non-recurring revenue and expenses and removing discretionary and personal expenses that are not necessary to operate the business.
Discretionary earnings takes it one step further to add back the owner's salary and benefits. The idea is that an owner-operator business is likely to be purchased by a buyer that will also be the owner-operator. As such, these prospective buyers are evaluating how much "discretionary earnings" they would have in the business. The key adjustment is to add back the owner salary and benefits, in addition to the adjustments to arrive at an adjusted EBITDA. This results in a higher amount than adjusted EBITDA and is primarily used for small businesses.
As noted above, EBITDA and discretionary earnings are commonly used in considering what the free cash flow of a business would provide, but are distinctly different. The key difference is that discretionary earnings includes a full add back of the owner's salary and benefits, while EBITDA would only normalize the cost of the management team in place if needed.
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Disclaimer: The information contained in this article is for general guidance only. The information presented should not be acted upon without the advice and guidance of a professional tax, legal, or financial adviser who is familiar with all the relevant facts.