November 11, 2023
Read time: 3 minutes

In small business M&A, the terms profit or income can mean many different things.

“This business prints cash.”

“This business is super profitable.”

“This business is crazy high margin.”

It’s easy to fall into the trap of assuming all profits are created equal.

They are actually quite different.

Understanding the nuances is key to properly analyzing a business.

In today’s newsletter, I’ll attempt to simplify the following:

  • EBIT
  • Adjusted EBITDA
  • Seller’s Discretionary Earnings
  • Free Cash Flow

Let’s drop the technical definitions and explain things like a 6th grader would.

The chart below will guide my commentary.

If you get lost, refer back to it.


Gross Margins

Most of us are familiar with a Profit & Loss Statement.

It’s an accounting deliverable that captures the difference between what a business makes (revenue) and spends (expenses).

The output is Net Income.

You’ll notice Net Income isn’t in our chart.

That’s because it’s a relatively low-value metric.

Net Income is affected by interest expense, amortization and taxes… stuff that often changes with new ownership.

Instead, when you analyze a P&L, focus first on Gross Margin:

Gross Profit divided by Revenue.

All else equal, the higher the Gross Margin, the more valuable a business.

Software, for instance, can have 90%+ Gross Margins.

A higher Gross Margin allows more room to invest in the business.

You can spend more on marketing, systems, and back office staff.

If I see a business with less than 30% Gross Margin I’ll often pass right away.

Very little room to invest in the business (and often points to commodity, rather than value-based, pricing).

Adjusted EBITDA v. SDE

How much cash does the business generate each year?

That’s what we care about.

So how do we get there?

Start by finding the EBIT line (or Operating Income) on the Profit & Loss Statement.

Add back Depreciation & Amortization because it’s a non-cash expense (meaning when incurred, no cash leaves the business).

Add back any non-recurring expenses. One-time projects like website redesigns or branding projects.

Boom—you’ve arrived at the oh so popular Adjusted EBITDA!

Generally speaking, this is the metric that mature businesses are valued on.

It reflects the ongoing profitability of a business.

However, in small companies, the seller of the business is often paying herself an above market salary + taking liberal benefits (meals, travel, etc.).

To getter a more accurate value metric, we need to add back the owner’s salary, including all benefits.

The result is SDE, or Seller’s Discretionary Earnings.

In theory, this is the amount of profit you as the owner-operator would keep if you ran the business yourself.

Brokers love to value a business as a multiple of its SDE.

But don’t be fooled.

The owner is often performing mission-critical work for the business. This includes operational roles like sales, people management, etc.

If it’s not going to be you, someone will need to perform that task.

So put a value on it.

In other words, always reduce the advertised SDE by the market cost to replace the owner.

It can be a conservative replacement cost, but it needs to be something.

The result is what I consider the true Adjusted EBITDA and often the metric I will use to defend my valuation.

Adjusted EBITDA v. Free Cash Flow

Valuation is one thing.

Cash flow is another.

And ultimately, cash is king.

So how do we know how much cash a business is actually making?

Calculate the true Adjusted EBITDA.

Then back out the historical capital expenditures (CapEx).

CapEx includes ongoing investments in machinery, equipment or other major purchases that are required to sustain operations.

You can find historical CapEx in the investing section of the cash flow statement. Consider the average balance over the prior 3 years.

The output of this calculation is a good proxy for Free Cash Flow.

If you were to buy a business and hire someone to run it, this is the cash the business generates at steady state.

It does not include your debt servicing costs (interest + principal repayment).

It does not include any corporate taxes you may owe.

It does not include any changes to net working capital.

But it does include everything else.

Final Thoughts

If your goal is to buy a small business, it’s critical that you understand these nuances.

Brokers love to play games with profitability metrics.

Never take their calculations at face value.

Start with the P&L and work backwards to derive the true Adjusted EBITDA and Free Cash Flow.

Base your valuation off a multiple of one of these.

To any veteran reading this newsletter, thank you for your service and for keeping us all safe.

We enjoy the freedoms we do because of your sacrifice.

I’ll see you all back here in 2 weeks,


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