Acquisition Analysis - Understanding the Terms

When analyzing a company for potential acquisition may incur under conditions that are unfamiliar to you as: net income, EBIT, EBITDA and SDCF. Having a thorough understanding of these terms and the relationship between them can be the difference between a good and a bad financial decision.

Net Income - Net income is an accounting term used to define the bottom line of the income statement. This is an accounting concept calculated as follows: Revenue - Cost of sales - Operating expenses = net income. Net profit is not the best indicator of the true financial performance of a company. Why? Because non-cash expenses such as depreciation are included in operating expenses that are subtracted from revenue. Depreciation and amortization expenses, which represent the theoretical "using up" of a company's assets (assets held at cost). Since depreciation is not cash, including costs in operating expenses and depriving them of revenue will reduce the tax liability of a company, but it will also underestimate the amount of money available to a potential buyer.

Net income is affected not only by the cost of goods sold, operating expenses and non-monetary costs, but also specific to the current property expenses such as interest expense. Since the current owner can maintain a level of debt that is not optimal, but specific to their personal situations, interest expense must first be stripped of the net income of a company's financial performance can be properly assessed. For example, consider a company that is "over-levered" (who have more debt on the books that the company can support and manage). This can only be verified because the owner has no additional money or capital to contribute to the business. Interest expense of society in this scenario is higher than that of an owner to maintain a lower level of debt. In order to evaluate the financial performance of the business, sans the financial situation of the current owner, a prospective buyer must remove the charges for interest and focus on costs specific to the business.

Another expense that should be excluded from your analysis acquisition fees. If we were to evaluate a company's net income, there would not only incorrectly assessed the effects of non-monetary costs on business (depreciation) and the impact of the financial situation of the current property (interest income), but also a tax effect which is based on a percentage of the number of income tax which is already distorted by these charges (depreciation and interest). Since we do not want to evaluate the company to include the current capital structure ownerships in our analysis (interest) and discretionary spending (of which more later) you must go above the fiscal effect on the income statement in order to completely remove their effect (and the effect they have on the corporate income tax).

EBIT - is an acronym for Earnings Before Interest and Taxes. EBIT provides a better indication of the true financial performance of a company's net profit for all the reasons stated above. EBIT is not distorted by the tax calculations of companies and the capital structure of the 'current owner. It is one of the best indications of the actual operating margin. Unlike EBITDA (discussed in the next section), EBIT in its calculation incorporates an annual allocation of expenditure for the obsolescence of fixed assets of the companies used for the production of income. This cost takes the form of depreciation for fixed assets and depreciation for intangible assets. EBIT is calculated as follows: Net Income + Interest Expense + Income Taxes = EBIT.

EBITDA - is an acronym for Earnings Before Interest, Taxes, Depreciation and Amortization. EBITDA is the best indicator of the actual cash performance of a company. She strips the company's fiscal effect, the current ownership of capital structure and eliminates the effect of non-cash expenses such as depreciation. Rarely is there a better metric to evaluate the actual cash available for the property at the end of a period of operation to reduce debt, pay taxes and offer investors a yield of EBITDA. EBITDA is calculated as follows: EBIT + Depreciation + Amortization = EBITDA.

In considering acquisitions of small companies often encounter another acronym SDCF. SDCF is the abbreviation for the seller discretionary cash flow. Seller discretionary cash flow assumes that the owner of the business also works for the business and requires a salary for services rendered. SDCF is calculated as follows: EBITDA + owner's salary = SDCF. It 'important to recognize that SDCF is not the return you will realize the risk you are taking as an owner or purchaser, but rather the combined return for the functions you perform on a day to day (salary or wages) and the return is required for the risk that you own. If SDCF is less than or equal to the wages of you (or a dependent) will need to run the day to day duties left vacant by the current owner, then you will receive a financial return on your investment. The return will simply compensate for a salary for their duties as an employee of the business.

We'll talk more about these parameters and how they should be used and analyzed in our next post. But for now, get comfortable with the terms. I see them often when evaluating companies for potential acquisition. You must learn to speak the language before you can make an informed buying decision reasonable and polite .......