In the world of small business finance and business valuation, two important terms often come up - SDE and EBITDA. As a small business owner, you may have heard these abbreviations thrown around, but the nuance between them can be confusing. In this article, we’ll dive into the world of SDE and EBITDA, understanding their definitions, their differences, and how, why, and when they are commonly used. 

What is EBITDA?

Let's start with EBITDA. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s a financial metric that provides a snapshot of a company's profitability by excluding certain expenses that are not directly related to business operations. Think of it as a way to measure the income generated by a company before taking into account interest payments, taxes, and the impact of depreciation and amortization.

EBITDA gives owners, investors, and buyers a clearer view of a company's core earning power, as it eliminates non-operational expenses that can vary from company to company. By focusing solely on the operational aspects of a business, EBITDA allows for more accurate comparisons between companies in the same industry.

Let's dive deeper into each component of EBITDA to understand its significance:

Earnings: Earnings refer to the profits generated by a company through its regular business activities. It’s the amount left after deducting all expenses, including the cost of goods sold, operating expenses, and non-operating expenses.

Interest: Interest expense represents the cost of borrowing money. It includes the interest paid on loans, bonds, and other forms of debt. By excluding interest from the EBITDA calculation, it helps to focus on the company's operational performance without the influence of its financing decisions.

Taxes: Taxes are the mandatory payments made by companies to the government based on their profits. Excluding taxes from EBITDA provides a clearer picture of a company's profitability before the impact of tax obligations, which can vary depending on factors such as tax rates and incentives.

Depreciation: Depreciation is the systematic allocation of the cost of tangible assets over their useful lives. It represents the decrease in the value of assets (like equipment) due to wear and tear, obsolescence, or other factors. Excluding depreciation from EBITDA, allows potential buyers to focus on the company's operational performance without the influence of non-cash expenses related to asset depreciation.

Amortization: Amortization is similar to depreciation but applies to intangible assets such as patents, copyrights, and trademarks. It represents the gradual reduction in the value of these assets over time. Excluding amortization from EBITDA provides a clearer view of a company's operational performance by removing the impact of non-cash expenses related to intangible asset amortization.

EBITDA is widely used in financial analysis and valuation because it provides a more comprehensive measure of a company's profitability and operational performance. That said, it’s important to note that EBITDA has its limitations and should not be the sole metric used to evaluate a company's financial health. It’s a helpful practice to consider other financial indicators and ratios in conjunction with EBITDA to get a holistic view of a company's performance, which is why Baton’s valuations use a variety of methods based on real financial data to give owners and potential buyers a clear picture of a business’s market value. 

What is SDE?

Now, let's talk about SDE. SDE, or Seller's Discretionary Earnings, is a term commonly used in the field of business valuation, particularly for small businesses. SDE is a measure of the total financial benefit that a business owner derives from the business.

When evaluating a business, it is important to consider not only its financial performance but also the owner's personal financial interests. This is where SDE comes into play. Unlike EBITDA, which focuses strictly on company performance, SDE takes into account the owner's salary, benefits, and other discretionary expenses.

As a small business owner, you have put in countless hours of hard work and dedication to make your business successful. Naturally, you would want to be compensated for your efforts. SDE recognizes this need by including the owner's salary in the calculation.

But SDE goes beyond just the owner's salary. It also considers other benefits that the owner may enjoy, such as health insurance, retirement contributions, and even perks like company cars or travel expenses. These discretionary expenses are added to the calculation to provide a more accurate representation of the owner's total financial benefit.

By including these discretionary expenses, SDE provides a comprehensive picture of the business's profitability. It recognizes that an owner's financial interests are intertwined with the business's success. After all, if an owner is not adequately compensated for their efforts, it may impact their motivation and ability to continue growing the business.

It is worth noting that SDE is particularly relevant for small businesses, where the owner's involvement and financial interests are often more significant. In larger corporations, where the owner's role may be more detached, other financial metrics like EBITDA may be more appropriate.

So, the next time you come across the term SDE, remember that it goes beyond just company performance. It takes into account the owner's personal financial interests and provides a more holistic view of the business's financial benefit.

What's the difference between SDE and EBITDA?

Now that we have defined both EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and SDE (Seller's Discretionary Earnings), let's dive deeper into the key differences between these two metrics and how they’re used. 

As we’ve just learned, EBITDA is a financial metric that looks solely at a company's financial performance and excludes various expenses that may not be directly related to day-to-day operations. It provides a measure of a company's operating profitability by focusing on its ability to generate revenue and control costs. By excluding interest, taxes, depreciation, and amortization, EBITDA allows potential buyers and investors to compare the financial performance of different companies without the influence of non-operational factors.

On the other hand, SDE takes into account the owner's discretionary expenses, providing a more holistic picture of the financial benefits derived from the business. It represents the total financial benefit that a business generates for its owner, including not only the company's profits but also the owner's salary, perks, and other personal expenses that are related to the business. SDE is particularly relevant for small businesses, where the owner's involvement and financial interest play a significant role in the business's success.

Understanding the difference between EBITDA and SDE is crucial when it comes to valuing small businesses accurately. While EBITDA is commonly used in analyzing larger companies, SDE provides a more comprehensive view of the financial performance of small businesses. By considering the owner's discretionary expenses, SDE captures the true financial benefit that the business provides to its owner.

When selling a small business, SDE gives potential buyers a straightforward way to assess the financial feasibility of a potential acquisition. It helps them understand the actual cash flow that they can expect to receive from the business, taking into account the owner's compensation and other personal expenses. This is especially important in the context of small businesses, where an owner's involvement is often closely tied to the business’s success.

Another key distinction between EBITDA and SDE is their relevance in different industries. While EBITDA is widely used across various sectors, SDE is particularly valuable in service-based industries, where the owner's expertise and personal involvement are critical to the business's operations. In such industries, the owner's discretionary expenses are a significant part of the overall financial benefit derived from the business, making SDE a more appropriate metric for valuation purposes.

In conclusion, EBITDA and SDE are both important financial metrics, but they differ in their focus and applicability. EBITDA provides a measure of a company's operating profitability by excluding non-operational expenses, while SDE offers a more comprehensive view of the financial benefits derived from a small business, taking into account the owner's discretionary expenses. Understanding the differences between these metrics is essential for owners who want to understand the true market value of their business, and to prepare for productive conversations with potential buyers.

What is better for business valuation?

When it comes to determining the value of a business, it's important to consider both EBITDA and SDE, as they provide different perspectives on a company's financial standing.

For larger companies with a professional management team in place, EBITDA is often the preferred metric for valuation purposes. It focuses solely on the company's operational performance and eliminates the impact of discretionary expenses, providing a clear and standardized way to compare companies within the same industry.

However, for small businesses, where the owner's involvement and financial interests are significant, SDE becomes a crucial metric. It captures the true financial benefits that an owner derives from the business, including salary and other discretionary expenses.

Ultimately, the choice between EBITDA and SDE depends on the specific circumstances and nature of the business being valued. It is essential to utilize the appropriate metric that aligns with the company's size, structure, and industry.

Common mistakes to avoid when interpreting SDE and EBITDA

Now that we have a solid understanding of both SDE and EBITDA, let's take a look at some common mistakes that can occur when interpreting these metrics.

Misunderstanding the concept of discretionary expenses

When calculating SDE, it's crucial to identify and properly account for discretionary expenses. These are expenses that the owner chooses to incur but are not necessary for the day-to-day operations of the business (for example, non-essential vehicle expenses). It’s important to accurately identify these kinds of expenses as an incorrect assessment can distort the value of the business.

Ignoring industry-specific factors

Different industries have varying levels of standard practices and expenses. When comparing companies using EBITDA or SDE, it's important to consider the specific dynamics and benchmarks of each industry. Failure to do so can lead to inaccurate valuation conclusions.

Overreliance on a single metric

EBITDA and SDE provide valuable insights, but they are just two pieces of the puzzle. It is crucial to consider other financial metrics, industry trends, and qualitative factors when conducting a comprehensive business valuation. Relying solely on EBITDA or SDE can lead to an incomplete and potentially misleading assessment of a company's worth. This is why Baton’s valuations offer much more than a valuation calculator — by taking into account your business’ unique business model and market advantages to give you a comprehensive picture of value. 

The benefits of knowing the difference between SDE and EBITDA

Understanding the distinctions between SDE and EBITDA can have significant benefits for business owners, potential buyers and investors, and valuation professionals.  

For business owners, understanding SDE allows for a better grasp of the true financial benefits derived from the business, helping them make informed decisions about pricing, growth strategies, and potential exit plans.

Potential buyers and investors can benefit from knowing the difference between SDE and EBITDA to accurately assess the financial performance of a company. By utilizing the appropriate metric for the specific circumstances, they can make more informed and reliable investment decisions.

And of course, business valuation experts must have a solid understanding of both SDE and EBITDA. Their ability to apply the right metrics for each unique business is critical to their ability to provide accurate and reliable valuation reports that ultimately lead to smooth transactions.

Conclusion

SDE and EBITDA are both crucial metrics in the world of finance and business valuation. While EBITDA focuses on a company's operational performance, excluding non-operational expenses, SDE provides a more comprehensive view by considering the owner's financial benefits. Understanding the nuances between these metrics and avoiding common misinterpretations is critically important for small business owners and potential buyers or investors to accurately gauge a business’s profitability.

It’s easy to understand why a buyer’s first question is often to understand these metrics, so they can quickly evaluate if the business’s profitability can support their living expenses and other goals. If you’re thinking about selling your business one day, getting a free valuation with Baton is a great place to start. It’s our mission to help small business owners plan for the future - with the same market data and insights that buyers have. Get started today to learn what your business is really worth and explore your selling potential.