Business investors need to understand how cash flow works in a business in order to meet their financial goals. It is also the way to compare different types of investment opportunities, for example, between investing an apartment complex or in a manufacturing business.
How they are alike: both SDE and EBITDA describe cash flow. If a business is operating as it should, it reliably generates more income than expense from its core activities. However, profit and loss statements do not provide the full picture. A business may also produce cash flow from investing or cash flow from financing activities. The three cash flows taken together produce the overall benefit to the owner. SDE and EBITDA describe operating income from core business activities.
SDE stands for Seller Discretionary Earnings. In a typical business where the owner is active in the business, the business has revenue come in and pays out all of its expenses. Whatever is left belongs to the owner. The owner may or may not pull all of the cash out of the business. Perhaps the owner reinvests in the company by expanding operations, purchasing equipment, or doing a costly repair. Seller Discretionary Earnings describe the total amount of cash the business will provide to the owner and that owner can do with it as they see fit, including pay themselves a salary and cover the other two types of cash flows, investing and financing. Investing can take the form of expanding operations, purchasing equipment, or setting up a money market account for excess cash. Financing involves the seller studying their opportunity costs for using a bank’s money (or investor’s) instead of their own. The cash flow may be positive or negative for any of the three types of cash flows. An owner compensates themselves for their time working in the business in addition to return on investment.
EBITDA is similar to SDE and stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. In other words, cash flow from operating activities. However, EBITDA is typically used when a business hires out business management to a professional such as a general manager. EBITDA summarizes the cash flow to an investor type of owner. The difference between SDE and EBITDA is the amount of daily activity provided by the owner of the business in which the expectation is simply ROI.
When purchasing a business, it is important to accurately distinguish between SDE and EBITDA models and multiples and also to accurately understand the complete cash flow situation your investing and financing will produce in order to be successful.