There are several occasions in a closely held company’s lifecycle when the overall business value is among the most important considerations. These milestones include:
- To a prospective buyer considering a purchase
- To the business owner(s) at the time of sale
- To leadership and management for strategic planning
- To the business owner(s) when planning an exit strategy
Any company’s value depends at least in part on its financial performance, and several measures are used to evaluate that performance and contribute to an overall business valuation.
Among the most commonly used measures are free cash flow (FCF) and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).
These measures offer critical insights into different, but both important, aspects of a company’s management, profitability, ability to generate revenue, and availability of cash.
In this article, we’ll take a look at how to calculate free cash flow starting with EBITDA, and we’ll take a closer look at what these values do and don’t tell us about business value.
What is EBITDA?
EBITDA is a useful measure in business valuation because it excludes the effects of certain business expenses that are less a result of management’s operating decisions, and sometimes more a result of simply being in business.
Quite simply, EBITDA is calculated by adding the following values, which can all be found on a typical profit and loss statement:
|EBITDA = net profit + interest + taxes + depreciation + amortization|
What is Free Cash Flow to Firm (FCFF)?
Free cash flow is a measure of the cash available from revenue to pay creditors and/or shareholders. Simply put, free cash flow represents the cash that the company still has after cash expenses (excludes non-cash expenses such as depreciation and amortization) and taxes, and the costs of investments in fixed assets and working capital are paid from the revenue. It’s the cash left after supporting operations and maintaining capital assets, if any.
How to Calculate Free Cash Flow From EBITDA
Free cash flow can be calculated from the cash flow statement starting with EBITDA, using the following formula:
|FCFF = earnings after tax + interest x (1 - tax rate) + depreciation & amortization ± Δ net working capital − capital expenditures|
Free Cash Flow vs EBITDA: Which is More Important?
Both measures have their place, and each one deserves consideration alongside the other. EBITDA can be quite helpful in comparisons of similar companies’ performance, because it strips out external factors to allow a focus on the financial results of management and operational strategies and decisions. EBITDA offers a way to judge a company’s profitability at a sort of baseline level.
On the other hand, free cash flow allows a business to demonstrate how well it generates and handles cash — from collecting payment to paying its own bills. Free cash flow is an important measure of how well-positioned a company is to pay down debt or make strategic investments that could improve its competitiveness. This is an important consideration, especially within rapidly changing market landscapes.
Obviously, the more information, insight, and perspective you can bring to the table, the better, whether you’re a business owner looking to sell, a potential buyer, members of leadership making strategic plans, or an owner just starting to evaluate potential exit strategies. Up-to-date, accurate financial statements are foundational for effective planning and management.
Generally speaking, it always makes smart business sense to use more than one measure to evaluate the financial health, profitability, and value of a company. Professional business valuation appraisers use multiple measures, along with significant industry research, before establishing a range of value.
EBITDA, Free Cash Flow, and the ESOP Exit Strategy
If you’re a business owner interested in discerning the value of your company with an eye toward making an exit, it’s worth investigating the option of selling to an employee stock ownership plan (ESOP). Not every business is an ideal ESOP candidate, but for those that are, selling a closely-held company to an ESOP offers owners a flexible exit strategy with many distinctive characteristics:
- It creates a valuable retirement benefit to recruit, retain, and reward loyal employees
- It leaves a legacy of employment in your community
- It allows you to maintain control over your exit horizon and succession planning by retaining your leadership role and becoming an employee-owner
- Its unique tax benefits help optimize cash flow for the business, positioning it for continued growth
Plus, unlike a traditional third-party sale, an ESOP sale can net a business owner up to 90-110% of the sale price, when tax benefits and transactional structures are optimized.
Learn more about how an ESOP can help you get the best value at sale for the business you’ve spent a lifetime building. Download our free eBook, How an ESOP Maximizes Value When You Sell Your Business. Just click the link below to claim your copy now.