Acronym of the day: EBITDA
Earnings before interest, tax, depreciation and amortization
The equation itself is really quite simple: subtract expenses from revenue (excluding interests and taxes) without depreciation and amortization (what you pay for tangible and intangible assets). The remaining number paints a basic picture of your profitability as well as your ability to pay off what it owes.
EBITDA is widely used in loan covenants. The theory is that it measures the cash earnings that can be used to pay interest and repay the principal. Since interest is paid before income tax is calculated, the debt-holder can ignore taxes. They are not interested in whether the business can replace its assets when they wear out, therefore can ignore capital amortization and depreciation.
EBITDA has also been used in determining a sale price of a business. Normally, multiples are derived from comparable companies operating in a comparable environment. e.g., Mid-size manufacturing companies operating in the United States should have the same multiples (P/E, EBITDA etc.) The key is to determine multiples of comparable companies and use this as basis for determining/justifying your own multiple.
Small businesses typically sell for a multiple of less than 5 times EBITDA. But when you plug in the numbers, there can be a big difference between 2 x EBITDA and 5 x EBITDA!