The EBITDA criterion in business valuation

Valuation of a company is essential for planning, selling and financing. The accurate valuation of a company involves (a) understanding of business (b) forecasting company performance (c) selecting the appropriate valuation model and (d) converting forecasts to a valuation.
The most frequently asked question is which ‘multiple’ is the right one with which to assess the value of a business, whether it is a large or small business valuation. Most business-owners believe that the EBITDA multiple (Earnings Before Interest, Tax, Depreciation, Amortization) is the best single criteria. However, only relying on earnings can be short-sighted.
Valuing a business requires a wide-scope approach. EBITDA, by its definition, removes the elements of financing and accounting decisions by adding back interest, depreciation and amortization and thus, can be used to compare the profitability between companies and industries. Further, it can analyze industry trends over time.
However for the valuation of a company, EBITDA is not always a good measurement for cashflow, even though cashflow is the most vital component for small & medium- sized businesses survival. Operating cashflow is a much better criterion for assessing cashflow since it includes the changes in working capital; more specifically accounts receivable, inventory and accounts payable. A comprehensive large or small business valuation will address this.
For example, relying only on EBITDA as value measurement, an analysis could easily neglect to find an inventory built-up due to poor product design, resulting in an increased need for financing or future margin erosion due to required discounting. Additionally, the need for more working capital as accounts receivable increase can cause a significant drain on cash, particularly for seasonal businesses.

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