Net profit, EBITDA and SDE: what's the difference?

By Vishal Bharucha, President of VNB Business Brokers, a leading business brokerage and M&A advisory firm.

Calculating the value of your business is an essential part of success. This is even more important than revenue because it doesn't matter without profit generation. Plus, it's an indicator of how much money you have left to reinvest in your business, which is key to future growth. If you're considering applying for a bank loan, it's also important to have a solid net profit, as banks use this to gauge the suitability of the loan and your ability to repay. Not only can this give you a clear picture of your company's financial situation, but it can also give your investors confidence that their money is going in the right direction.

This article provides an overview of the differences between net profit, EBITDA and SDE, and how these variables measure business value.

Net gains

Net profit, or bottom line, is an important factor in determining the success of your business. The formula is simply the amount of money left after you deduct all of your business expenses from total income. However, it does not include the tax. Since the tax is based on a percentage of your net income, you can only calculate it once you have arrived at your net profit figure.

Net income isn't just the only metric to evaluate your business. There is also Earnings Before Interest, Taxes, Depreciation, and Amortization – also known as EBITDA – and Seller's Discretionary Earnings – also known as SDE. But what's the difference between the two, and which is better for your business?

EBITDA

While net income reflects your company's total revenue, EBITDA indicates your company's consistent ability to earn profits, hence your company's value.

EBITDA is a commonly used measure in medium and large companies. To get a deeper understanding of the variables involved in EBITDA, here is a breakdown of its key terms: interest (expenses caused by interest rates, e.g., bank loans), taxes (federal income taxes and imposed by the government), depreciation (non-cash expenditure of reducing the value of assets on fixed assets of the company) and amortization (non-cash expenditure of intangible fixed assets).

The formula to calculate Regular EBITDA is:

Net income + Interest expense + Depreciation expense + Depreciation expense + Taxes

However, companies are usually valued over several adjusted EBITDAs. In an article by Windes, an adjusted EBITDA is often used as a hybrid model where the buyer is a financial buyer and the seller receives a higher salary than a non-owner manager. This is common when the buyer is a private equity group.

Adjusting EBITDA means removing all one-time expenses to normalize salary. For example, if you pay yourself an annual salary of $250,000, but an acquirer can replace you with a manager who earns $200,000, you would add $50,000 in excess salary.

EPS

SDE is a metric used to track a company's cash flow history. This is simply your net profit with add-ons. By definition, add-ons are expenses added to your bottom line to improve the value of your business. This is a commonly used valuation metric in small businesses. It outlines the financial benefits potential buyers would potentially receive if they were full-time owners/managers.

The main difference between EBITDA and SDE is what it suggests about the performance of your business. According