Village Wellth

Determining Cash Flow for Small Business Acquisitions

When acquiring a small business, one of the most critical steps is assessing its financial health and determining its valuation. Cash flow is the foundation of any business valuation, and two primary metrics are used to measure it:

EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization
SDE: Seller’s Discretionary Earnings

Understanding how and when to use each metric can help buyers make informed decisions about a business’s true value and affordability.

What are EBITDA and SDE

EBITDA is commonly used in business valuations because it removes external financial factors like financing costs, taxes, and depreciation. It gives a more accurate view of a company’s ability to generate cash flow independent of choices made around debt financing and tax environment. However, it does not represent actual cash flow, as expenses such as debt payments and taxes still need to be accounted for.

SDE is EBITDA with owner’s compensation and benefits added back. This metric is particularly useful for small businesses where the owner's salary varies widely based not on that individual’s value to the business, but rather on their personal tax planning. Since owners often compensate themselves through a mix of salary, dividends, and perks, SDE helps normalize the earnings to reflect what cash flow is available for a future owner to reward their own efforts.

Why do these Metrics Matter

For buyers, the two cash flow measures can serve unique but complimentary purposes. Small business acquisitions often involve the buyer stepping into an active role in the company. Because of this, how the previous owner compensated themselves can significantly affect the company’s reported earnings.

For example, if a business owner paid themselves a high salary or took large dividends, the reported EBITDA might seem low, but the SDE would provide a clearer picture of the true earnings potential. Contrarily, if an owner underpays themselves, EBITDA could overestimate the business’s actual profitability.

When to Use EBITA vs. SDE

Valuation:

A clearer range of business valuation can be obtained by employing a variety of metrics. Typically, buyers use:

EBITDA with a 3-4x multiple for valuation
SDE with a 2-3x multiple for valuation

Because owner compensation varies significantly, EBITDA is often preferred for valuation, as it provides a more standardized measure of a business’s profitability. However having both metrics available could provide you with an additional frame of reference for your valuation proposal.

Affordability:

When considering whether you can afford a business, SDE provides a better measure. If an owner previously took home $200,000 but a new owner only needs $100,000, SDE gives you the correct benchmark to start your personal affordability calculations. Both metrics provide you with a blank slate for planning debt financing and capital expenditures.

Key Takeaways

Understand both EBITDA and SDE: Knowing how a seller arrived at both figures is essential.
Use multiple valuation methods: Applying different multiples to EBITDA and SDE can help triangulate a fair purchase price.
Prioritize SDE for affordability: It provides a clearer picture of how much cash flow will be available for owner compensation, debt repayment and capital investment.
Recognize that SDE can vary widely: Since it includes owner compensation, it may not always reflect true profitability under new ownership.

By understanding the differences between these key financial metrics, buyers can make more informed acquisition decisions and negotiate better deals. Whether you’re buying your first small business or adding to your portfolio, knowing when to rely on EBITDA vs. SDE can make all the difference in securing a successful investment.

╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍╍

Do you need help getting financing to acquire a business?

Buyers using Village Wellth have a 70% success rate in purchasing a business, compared to just 30% when going solo. Our advisors at Village Wellth can help you secure favourable lending terms and work with multiple banks on your behalf.
Find out how we can help you secure your business acquisition