EBITDA is an acronym for earnings before interest, taxes, depreciation and amortization and is often used to measure the value of some businesses. It can also be used in the comparison of similar companies.
The EBITDA formula can be used as a guideline when valuing larger companies, or when comparing the profitability of large similar companies in the same industry.
For the effective use of EBITDA, these larger companies should possess significant assets, have heavy amortization schedules, or bear substantial amounts of debt. Considering independent pharmacies don’t meet those criteria, this formula is not a useful measure as the sole means for valuing pharmacies for acquisition purposes.
Generally EBITDA makes it easier to evaluate various companies and to compare them against industry averages by removing the irregular and non-core operating costs such as interest, which can vary depending on the management’s choice of financing, taxes which can fluctuate depending on acquisitions or losses from prior years and arbitrary factors of depreciation and amortization.
1. Calculate net income by obtaining total income and subtract total expenses.
2. Determine the total amount of taxes paid to federal, state, and local governments.
3. Compute interest fees paid to companies or individuals for the use of credit, or capital.
4. Establish the cost of depreciation (the expense recorded to allocate a tangible asset’s cost over its useful life).
5. Determine the cost of amortization (the expense for consumption of the value of intangible assets, such as goodwill, patents, and copyrights, over a specific period of time, or the asset’s expected life.
6. Add #1 through #5.
EBITDA calculation example:
1. Net Income 5,000
2. + Taxes paid 1,500
3. + Interest Expenses 1,000
4. + Depreciation 500
5. + Amortization 250
6. = EBITDA 8,250
During the 1980s EBITDA was being used as a proxy for cash flow in leveraged buyouts to calculate whether companies could service their debt. Factoring out interest, taxes, depreciation, and amortization can allow an unprofitable business to appear financially healthy. The dotcom era was notorious for using this method of valuation to make unprofitable businesses look good on paper. With little earnings and fewer assets the results from that method caused many to go bust. This was a blaring example of misapplying EBITDA.
Pharmacy Industry Specialists performing retail business valuations will use EBITDA in pharmacy valuations, but only as part of a larger formula when computing values for specialty pharmacies especially those who have a niche in HIV, disease management, long term care and home infusion. However, EBITDA should not be used as part of the usual formula for standard retail pharmacy acquisitions.
The EBITDA number for a specific existing pharmacy is important for the most part, when the current owner is establishing their store value for the purpose of borrowing, creating a Trust, adding a line of credit, stock values, etc., but EBITDA does not impute the same importance when selling a pharmacy. This is due to the fact the buyers expenses are not the same as the sellers.
Buyers may not have the same tax base, interest expense, or the same depreciation schedule, thus it is important that the buyer calculate an estimated EBITDA that is specific to their operating model, business systems, buying power, cost of operations, etc., not the sellers. It should also be noted that EBITDA assumes that the buyer will acquire all of the assets, working capital, accounts receivable, and liabilities. These assumptions do not hold true regarding an acquisition of a pharmacy. Instead of the EBITDA number pharmacy buyers should be focusing on sales, cash flow, gross profit and customer mix.