SDE and EBITDA. Two key metrics that come to mind when evaluating a business’s profitability, and their differences are most likely overlooked by many business owners.
First, let’s define each term and come up with their differences in this article.
Quick Key Takeaways
- SDE and EBITDA are both key metrics for evaluating business profitability.
- SDE includes owner compensation, providing a realistic view of cash flow.
- EBITDA focuses on operating profitability, excluding non-operating expenses.
- SDE accounts for all operational expenses, while EBITDA excludes interests and taxes.
- SDE is typically used for small business valuations, while EBITDA is used to value larger businesses such as corporations.
What is SDE?
The Seller’s Discretionary Earnings or 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 essential for small business owners because of 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.
How to Calculate SDE
To calculate SDE, here’s a basic formula:
SDE = Net Income + Owner’s Salary + Non-cash Expenses + One-time Expenses + Interest Expense + Non-operating Expenses
Let’s go through each of these components:
- Net Income: This is the net profit or loss of the business after all expenses have been deducted from revenues.
- Owner’s Salary: The SDE calculation adds back the owner’s salary to account for the fact that the owner may choose to pay themselves more or less than what a typical manager would earn.
- Non-cash Expenses: This includes items like depreciation and amortization. These are expenses that reduce net income but do not represent an outflow of cash.
- One-time Expenses: These are unusual or non-recurring expenses. For example, if the business incurred an unusual legal expense one year, this would be added back in the SDE calculation.
- Interest Expense: If the business has debt, the interest expense is added back because it’s assumed that the new owner may have different financing arrangements.
- Non-operating Expenses: These are expenses that aren’t directly tied to the core operations of the business. For example, if the business owner takes a trip to attend a conference that isn’t directly related to the business, the cost of that trip would be added back to calculate SDE.
What is EBITDA?
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.
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.
Fortunately, if you’re looking to sell your business through financing, there are several tax benefits when you do so.
How to Calculate EBITDA
To get an accurate representation of EBITDA, follow this formula:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
Let’s break down each of these components:
- Net Income: This is the company’s total earnings (or profit). This is calculated as revenues minus expenses, interest, and taxes.
- Interest: The interest expense the company has from any debt it has taken on. Adding it back to net income helps analysts understand the company’s profitability without the impact of how it has chosen to finance its operations or capital expenditures.
- Taxes: Adding them back to net income helps to focus on operational profitability, as tax environments can vary greatly and are generally outside of the operational control of the company.
- Depreciation: This is a non-cash expense that companies incur due to the use of long-term assets, like machinery or equipment, over time. Depreciation is added back because it is a non-cash expense and thus does not represent a cash outflow.
- Amortization: This is a non-cash expense related to the gradual reduction in value of intangible assets, such as patents or trademarks. Like depreciation, amortization is added back because it does not represent a cash outflow.
EBITDA can be a useful measure of operational profitability, especially when comparing businesses across different industries.
However, it’s important to note that it’s not a measure of net income or cash flow, and it doesn’t take into account the cost of capital investments like new machinery or equipment.
Need a Hand with Valuation?
Metrics like SDE and EBITDA can be a headache, especially when you’re figuring it out all on your own.
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SDE vs EBITDA: Understanding their Differences
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.
Let’s break it down for easier digestion.
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.
Expense Inclusions
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 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 suited for larger businesses such as corporations. 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.
Let’s learn what you can get from this analysis.
When should I use SDE?
Seller’s Discretionary Earnings is tailored for small businesses where the boundaries between profits and owner’s pay are blurred—in other words, finding the accurate historical cash flow. Owners may forgo a fixed salary or undercompensate themselves while deducting personal expenses from the business.
SDE merges business earnings and owner’s pay into a single measure—giving a clear picture of potential earnings for prospective owners.
This is invaluable for small business evaluations due to the intertwined nature of profits and owner’s pay and the subjectivity in setting a manager’s salary.
Moreover, it is often utilized for enterprises with less than $1 million in SDE, popular among business brokers dealing with owner-managed businesses.
When should I use EBITDA?
EBITDA is a popular valuation metric for mid-sized businesses, typically those with over $1 million in EBITDA.
It accounts for an owner-operator’s salary, which is normalized to market levels regardless of the actual salary drawn. If the owner’s salary is absent or below the market rate, EBITDA calculations incorporate a market-rate deduction.
This principle also applies when the business is purchased by other entities, such as a private equity group, as they would need to hire a manager and pay a market-rate salary. For example, with an SDE of $1 million, if a manager is paid $200,000, the EBITDA would be $800,000.
Therefore, EBITDA is beneficial for mid-sized business valuations, often used by M&A advisors and investment bankers, as well as a common metric for public companies.
SDE vs EBITDA: What to Take Note
Oftentimes, smaller businesses are typically valued as a multiple of the Seller’s Discretionary Earnings (SDE), which, in this case, looks like this:
EBITDA + Owner’s Compensation
With this, SDE is the net income on the company tax return + interest expense + depreciation and amortization expense + the current owner’s salary.
Final Thoughts
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!
