professionals they can afford to help them minimize taxes there will be little more said on the subject.
Interest is of course a consequence of cash on hand or debt, which is a component of the company's capital structure (how the business is financed by the owners). Debt and its implications will be revisited when leverage is discussed in Chapter 9.
Depreciation and Amortization, as stated earlier, is a period expense that results from depreciating or amortizing assets over their useful life. Once money is spent on an investment, the investment is capitalized on the company's balance sheet and then written off by periodic charges to the D&A account on the Balance Sheet via the Income Statement over the asset's useful life. Successful management teams consistently make investments that provide a recurring contribution to income greater than the associated periodic D & A.8
Special Case: Ignoring the Interest Component
While debt and associated costs must be thoughtfully managed, when it comes to creating value, management's prime responsibility is to focus on what happens to the money invested in the business. In fact well-managed private and public companies don't want their management teams spending a lot of time on financial engineering. As far as management is concerned capital structure need only be addressed periodically when the company needs funds to finance such things as a major acquisition. Investors want their team to concentrate on creating value, which is done by growing the top and bottom lines of the Income Statement. When it's appropriate to ignore the “Interest” component, then Equations [1-11] and [1-12] become Equations [1-13] and [1-14] respectively.9
[1-13]NI = (EBIT)(1 − TR)
[1-14]NI = (EBITDA − D & A)(1 − TR)
Example 1-1: Calculating Net Income
Using the data in Table 1-1 and Equations [1-2], [1-11], and [1-12] show that the Net Income in each case is $6,900,000.
Applying Equation [1-2] and substituting values for each of the terms from Table 1-1 gives an NI of $6,900,000 as expected.
[1-2]NI = Rev − COGS − OpExp − D & A ± NetInt − TaxesPaid
NI = 100,000,000 – 40,000,000 – 43,500,000 – 5,000,000 – 4,600,000
= $6,900,000
Similarly, applying Equation [1-11] gives the same result.
[1-11]NI = (EBIT ± NetInt)(1 – TR)
NI = (11,500,000 – 0)(1 – 0.40) = (11,500,000)(0.60) = $6,900,000
Finally, substituting in Equation [1-12] shows that all three equations yield the same amount for the Net Income.
[1-12]NI = (EBITDA – D & A ± NetInt)(1 – TR)
NI = (16,500,000 – 5,000,000 – 0)(1 – 0.40) = (11,500,000)(0.60) = $6,900,000
Why EBITDA?
The reader may have noticed that after analyzing the Income Statement in terms of various definitional equations the discussion seems to have settled on a couple of equations built around EBITDA. As will be seen later, it turns out that EBITDA is often an excellent proxy for a company's ability to generate cash flow.
There are only two business reasons to own or invest in a company. One is that the company will grow its earnings and therefore value. The other is to receive dividends from the cash flow. In practice, it is often a combination of both. In order to generate cash a company must be profitable and have Net Income.10
Furthermore, because of the correlation between EBITDA and Cash Flow, EBITDA can be used as a proxy for Cash Flow and therefore it is useful in valuing a business. The valuation of companies is the subject of Chapter 4. However, since Chapter 4 is several chapters away, the role that EBITDA plays in valuation is illustrated by Example 1-2. Before moving on to the example it's necessary to say a few words about something called an industry multiple.
Industry Multiple
Briefly, an industry multiple is an indication of the value investors assign to the industrial sector a particular company serves and the company's ability to create EBITDA and future cash flows. These multiples can vary over a wide range from near “1+” to “20+.” For the purpose of this example the industry multiple is assumed to be nine (9).
Example 1-2: Using EBITDA to Value a Company
Companies can be valued in a number of ways, including the present value of cash flows and/or an appropriate industry multiple. When the applicable multiple is known, the value calculation is straightforward. There are instances where the multiple isn't readily available, nor for that matter are the cash flows. In instances such as this, an estimate of an industry multiple can be made by making use of historical and forecasted financial statements and using the Revenue and EBITDA growth rates to estimate a suitable multiple.
(a) Valuing a Company Using the Industry Multiple
In its simplest form a company can be valued by using the following relationship:
[1-15]Value = (EBITDA)(Industry Multiple) – Debt + Excess Cash
In the interest of simplicity it is assumed that the cash shown on the balance sheet in the following and other examples is necessary for the day-to-day operations of the company and therefore the excess cash is zero and Equation [1-15] becomes Equation [1-16].
[1-16]Value = (EBITDA)(Industry Multiple) – Debt
The company represented by the Income Statement (Table 1-1) has an EBITDA of $16,500,000. According to the Balance Sheet (Table 1-3) the company doesn't have any Debt. Since the industry multiple is 9, an indication of the company's value is obtained by substituting in Equation [1-16].
Value = (16,500,000)(9) – 0 = $148,500,000
If the company had $10,000,000 of debt, then the value would be
Value = (16,500,000)(9) – 10,000,000 = 148,500,000 – 10,000,000 = $138,500,000
Why is debt subtracted? Consider the following. Assume someone purchased the company for $148,500,000 and rather than zero debt, it had $30,000,000 of debt. The buyer would be assuming responsibility for the $30,000,000 obligation. Since this debt ultimately has to be paid off, the total cost to the buyer would be $178,500,000. Now, one may note that the company has cash and it's reasonable to ask who gets the cash when a company is sold. The answer is, it all depends. Typically if the cash is necessary to fund the day-to-day operations (Working Capital), then it stays with the company. If there is excess cash, the seller normally keeps the excess.
(b) Valuing the Company If the Industry Multiple Isn't Known
The valuation in Part (a) of this example is only an indication of value. The correct way to value a business is to calculate the present value (PV) of future cash flows. However, since present value techniques are the subject
Depreciation and Amortization are discussed in more detail in subsequent chapters.
This assumption is almost always valid during the initial stages of the business planning process.
