EBITDA explained

In recent months, we have seen a big increase in the number of mergers and acquisitions being reported in the legal press, with the likes of Knights plc and other listed firms prepared to fork out significant sums for firms that fit with their expansion plans.

Not all deals result in large pay-outs of course, but where they do, the amounts involved are often linked in some way to the target firm’s EBITDA.  This is now so common that Business Valuation Benchmarks produce regular BVB Insights reports, providing details of normalised EBITDA multiples for hundreds of transactions across c40 industries, including a number of high-profile transactions in the legal sector.

So what is EBITDA, and why do we use it?

EBITDA stands for earnings before interest, tax, depreciation and amortisation, and is a metric used to understand the underlying profitability of a business.  The calculation eliminates any impacts from the non-operating and funding decisions made by management, such as interest on borrowings and depreciation on fixed assets.

Because interest, tax, depreciation and amortisation are almost always an expense in a firm’s accounts, the EBITDA is usually higher than the net profit reported in the Profit and Loss Account.

By removing the capital investment and financing variables in a business, EBITDA better reflects the overall operating profitability, and by levelling the playing field between different businesses across different industries and sectors, it can be used to directly compare one firm against another.

For example, let’s imagine two law firms (A and B) with annual fee income of £5m.  As far as day to day operations go, the two firms are very similar, except that firm A used to be a partnership and recently incorporated into a limited company, and firm B has always been an LLP.  In addition, firm A recently invested significant sums on new IT kit, whereas firm B plans to do something similar next year.

If we were to look at both firms’ profit and loss accounts, we would see the following:

 

Firm A                 Firm B

Fee income

5,000                   5,000

Staff costs

(2,250)                 (2,250)

Other operating costs

(1,000)                 (1,000)

____                    ____

 

Operating profit

1,750                   1,750

Depreciation on new IT kit

(150)                          –

Interest on directors’ loan accounts

(175)                          –

Amortisation of goodwill

(500)                          –

____                  _____

 

Net profit before tax

£ 925                £ 1,750

 

On the face of it, firm B is more profitable (and potentially worth more) than firm A, even though the underlying profitability (shown by the operating profit in the example above) is exactly the same in both firms.  Charges for things like amortisation and depreciation are accounting adjustments, and interest paid to directors is usually part of a tax-efficient remuneration strategy, rather than a true external cost.

Focusing on EBITDA avoids these issues, and as it excludes accounting adjustments, EBITDA is often viewed as a proxy for cash generated by a business from its ongoing operation – a key consideration for potential investors.

EBITDA is a useful tool when valuing a business, and when it comes to valuing a law firm, a common approach is to establish a maintainable EBITDA figure to which a multiple can be applied. The multiples used depend on a number of factors, such as other recent transactions in the sector, barriers to entry, overall size of the business and any niche specialisms.

It is important not to rely only on the EBITDA figure though.  Part of the reason for this is that different people can calculate EBITDA in different ways.  For example, some people deduct interest receivable within the “i” part of the calculation, and others do not.  Despite record low bank base rates, interest income is still a significant figure for many law firms, and including or excluding it can make a big difference to the EBITDA.

Another drawback of the EBITDA approach is that it ignores working capital (i.e. work in progress and debtors), and so firms that are asset-heavy can look healthier than they are.  As we all know, Cash is King, particularly at the moment, and there are plenty of recent examples of highly profitable firms going under due to a lack of cash.

Despite these drawbacks, EBITDA is one of several tools used by investors to gain a deeper understanding of the overall performance of a firm, and it is worth taking a look at the EBITDA for your firm.

The author of this article is Andrew Harris of Hazlewoods. Andrew can be contacted at andrew.harris@hazlewoods.co.uk or 01242 246683. Other members of ALFMA can be contacted here.

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