If you’ve read the post regarding how private equity funds can pay so much for companies, you’ve learned that the key to private equity investing is the ability to borrow the funds necessary to acquire companies. The more an acquired company can borrow and service, the greater the return to the private equity investor when the business is sold. The amount of debt that can be serviced is a function of the cash a business generates. The financial metric that best illustrates how much cash a business generates is EBITDA – your earnings before interest, taxes, depreciation and amortization. Basically, you start with your net income and add any interest paid on your debt (which will be retired in the sale), your cash taxes, and the noncash charges resulting from depreciating your physical assets (property, plant and equipment, for example) and amortizing (reducing the book value of) your intangible assets. That number – your EBITDA – reveals how much cash your business generates and therefore how much of the purchase price for your business can be borrowed.
We shouldn’t finish this discussion without an appreciation of capital expenditures, or CAPEX. CAPEX (buying equipment, expanding a factory, buying spares) certainly consumes cash that might otherwise be used to service debt. As a result, in the case of companies that require significant CAPEX year-over-year, many investors will reduce your “EBITDA” by the average CAPEX (or cash) the business requires.