Take the bottom line of your income statement and add back all those items (interest, taxes, depreciation, and amortization). Simple, right? But understanding EBITDA and why it's important is what matters to you.

Topic for Discussion: Why the focus on EBITDA?

Answer: The EBITDA is probably the single most important factor in the buyer's evaluation of the acquisition target because it represents cash flow from operations. The purchase of your business is an investment from the buyer's point of view, and he or she will calculate the return on that investment. This return is generally calculated in the traditional percentage manner as well as in terms of the "payback period."

The payback period is calculated based on how many years it takes to recoup the cash and/or stock investment.

The more profitable the business, the higher the price the buyer will pay because the business will provide an economic return justifying a larger investment. EBITDA isn't the only thing the buyer will evaluate. If your business operates with a significant investment in equipment, the buyer will have the equipment appraised. What kind of capital investment will be required beyond the purchase price? If your equipment is aging and needs to be replaced, this could have a big impact on the purchase price.

Necessary capital improvements are considered separately by the buyer, that's why depreciation and amortization are not included in EBITDA.

Topic for Discussion: Why add back taxes to calculate EBITDA? Isn't that a cost paid from cash flow? Won't the buyer have to pay the same taxes you did?

Answer: You bet! There's an old Yiddish proverb, "You make your money; you pay your taxes." CPAs like to say that you can't let the tax tail wag the economic dog. Yes, the buyer will pay taxes on the profits of your business and yes those taxes will come out of the cash flow of the business. The reason taxes are not considered in the valuation of your business is because the buyer is considering your business as an alternative investment.

Wherever the buyer invests, assuming there is an economic return, there will be tax consequences. So whether the buyer is a publicly-held company, as in our stories of Tracy and Bob, a privately-held company, or individual(s), the future tax liability from the profits of your business are not part of the valuation model.

The same is true of interest. The buyer will take into consideration the cost of money, to be sure, but as with the capital improvements that may be required; the buyer's cost of money is independent from your cost of money. So just as the buyer will "add back" the depreciation and amortization you have recorded each year, he or she will similarly add back interest and take into account his or her own cost of financing the transaction.

If you pay yourself above industry standard, don't worry. Buyers realize this and will deduct from your overhead the salary and benefits you have been paying yourself. A new buyer will use what is called recasted numbers to determine the value your company holds for them.

You think about it: Have you ever calculated your EBITDA? If not, why not? Do you think it is time to do it?