EBITDA is a common accounting term that is used with sophisticated small businesses, it stands for Earnings Before Interest, Taxes, Depreciation and Amortization.
EBITDA is basically the actual cash flow profit of the business based on the actual expenses of the business.
There are two categories of items in EBITDA, one category is Taxes, which covers three of the items, amortization, depreciation and taxes themselves. Debt service expense is the other category, which covers the interest on the debt service that a business is paying for things such as equipment loans, and lines of credit.
Because a buyer is going to have their own unique tax situation and most likely a different debt situation, the EBITDA figure allows a buyer to figure out his/her cash flow projections.
In an Asset Sale Purchase Transaction of a business, the buyer creates a brand new Depreciation and Amortization schedule, and usually a new debt situation. Under a stock sale transaction, a buyer would inherit the balance sheet and thus maintain/inherit the schedule of amortization, depreciation, interest that was in place with prior to the transaction.
Amortization pertains to the booking of expense on cash flow statements of intangible property of a business, such as goodwill, intellectual property, patents, contract rights etc.
Depreciation pertains to the booking of expense on cash flow statements of tangible property of a business such as Furniture, Fixtures, and Equipment.
Interest pertains to any interest paid on debts owed by the business, such as acquisition loans, inventory financing (flooring), equipment financing or lines of credit.
Taxes pertains to the Tax obligations due by the entity owning the business, including federal state and local taxes.
How does EBITDA differ from SDE?
There is one major difference between EBITDA and SDE. SDE adds back the salary of the owner. EBITDA does not add back the salary of the owner, which means the SDE is going to be a higher figure than the EBITDA.