As a business owner, understanding your company’s financial performance is crucial to its success.
However, navigating the world of finance can be overwhelming, especially when it comes to deciphering terms like SDE and EBITDA. These two metrics are important tools for evaluating profitability, but their differences can be confusing.
Fortunately, you’ve discovered a hidden gem. We’ll be diving into the differences between SDE and EBITDA, and I promise to make it slightly more exciting than watching paint dry.
By the end of this article, you’ll be able to impress your accountant with your newfound financial knowledge and maybe even show off to your friends at your next dinner party.
Without further ado, let’s get started!
What is SDE?
The Seller’s Discretionary Earnings (SDE) measures the cash flow available to the business owner after all expenses and taxes are paid. SDE is unique because it includes owner compensation, which is often neglected by other metrics, leaving small business owners feeling neglected.
Calculating SDE is simple: just start with net profit and add back any non-cash expenses such as depreciation, amortization, interest expense, and of course, owner compensation. Owner compensation is not an expense in SDE but an adjustment to net profit.
SDE not only helps small business owners value their business and set realistic asking prices when selling, but it also enables them to compare their performance with other businesses in the same industry. Think of SDE as the great equalizer, giving small business owners a fighting chance against the big players.
In short, SDE is like a magic wand for small business owners, swooping in to save the day with its comprehensive view of a business’s financial performance. This helps you make informed decisions about your business’s future and be the hero of your own entrepreneurial story.
What is EBITDA?
While some may argue that EBITDA is not a perfect metric, it’s hard to deny that it’s a crucial tool for evaluating the financial performance of large businesses with significant capital expenditures.
EBITDA simply starts with your net profit and adds back interest, taxes, depreciation, and amortization expenses. Interest expenses are like the interest you pay on your credit card debt, only on a much larger scale. Taxes are the government’s way of reminding you that nothing in life is free, especially not your right to operate a business. And depreciation and amortization expenses are the non-cash expenses that account for the decline in the value of the business’s assets over time.
Fortunately, if you’re looking to sell your business through financing, there are several tax benefits when you do so, thus, there’s no need to worry.
Furthermore, EBITDA is particularly useful in the context of mergers and acquisitions, where it’s often used to evaluate the operating profitability of a business. Moreover, it provides a clearer picture of a company’s financial performance, making it easier to compare it to other businesses in the same industry.
It’s like comparing apples to apples, only with a little less juice and a lot more money.
Key Differences Between SDE and EBITDA
SDE and EBITDA are calculated differently and focus on different aspects of a business. SDE is mainly used for small businesses while EBITDA is commonly used for large businesses.
Still needing more details? Don’t worry, we’ll break it down for you.
Applicability to Small vs. Large Businesses
When it comes to financial metrics, SDE and EBITDA are like different sizes of suits. SDE is tailored for small businesses with only a handful of owners, while EBITDA is a bespoke suit for larger companies with significant expenses. For small businesses, it’s essential to factor in owner compensation when calculating SDE, since they’re often very hands-on in running the business.
For big companies, the board of directors and senior executives are paid differently from the profits, which is why EBITDA doesn’t include owner compensation.
Another difference between SDE and EBITDA is the expenses included in each metric. SDE includes all expenses related to the operation of the business, including owner compensation. EBITDA, on the other hand, excludes non-operating expenses such as interest and taxes.
This is because EBITDA focuses solely on the operating profitability of the business, which is why it’s often used in the context of mergers and acquisitions. Removing non-operating expenses provides a clearer picture of a company’s financial performance, making it easier to compare it to other businesses in the same industry.
Business Type & Suitability
When it comes to financial metrics, it’s important to use the right tool for the job. And just like a carpenter needs different saws for different cuts, businesses need different metrics for different purposes. SDE and EBITDA are two such metrics, each suited for a particular type of business.
SDE is like a Swiss Army knife, versatile and practical, but best for small businesses that are owner-operated or have a few partners. These businesses may not have the same level of financial complexity as their larger counterparts, making SDE a more appropriate metric for evaluating their financial performance. With SDE, you can factor in things like owner compensation and discretionary expenses to get a more accurate picture of the business’s earnings.
On the other hand, EBITDA is like a power tool, capable of handling larger and more complex jobs. This metric is commonly used for publicly traded companies or those that have a significant amount of debt or capital expenditures. Think of EBITDA as a way to see how much money a business could potentially generate if you strip away certain expenses, like interest payments or depreciation.
It’s a useful tool for comparing businesses across different industries or when making investment decisions.
Which metric should I use?
The metric you choose to evaluate your business depends on the size and complexity of your company. Suppose you are a small business owner or have only a few partners. In that case, SDE might be the best metric to use as it considers your compensation and provides an accurate representation of the available cash flow for you as the owner.
However, if you are operating a large company or planning to acquire one, EBITDA might be the more appropriate metric to use. This gives a better indication of the operating profitability of the business, which is crucial when assessing its financial health.
It’s important to note that both metrics have their limitations. SDE doesn’t account for the cost of capital, which is the return investors could receive if they invested their money elsewhere. EBITDA also does not factor in changes in working capital, which can significantly affect a company’s financial performance.
Basically, if you’re running a business, it’s important to know your financial metrics, like SDE and EBITDA. It’s not rocket science and it’s not every day that you encounter these numbers. However, it will certainly give you a competitive edge. The key is to pick the right one based on your business’s size and complexity.
Understanding the difference between these two metrics will help you make smart choices for your business. In addition, knowing how to leverage these metrics means knowing what your business value is. You can use our free Business Valuation Tool that lets you get an idea of your business’s value if you’re planning to sell it.
You’ve managed to come this far, so contact us today to learn more about how we can help you sell your business successfully!