Accurate estimation of a company’s cash-generating ability is critical for SBA 7(a) business valuations. While EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) serves as a proxy for operating performance, it does not represent Free Cash Flow (FCF). Misinterpreting EBITDA as FCF can inflate valuations and misguide lending decisions. This white paper examines the differences between EBITDA and FCF, their roles in small business valuation, and implications for SBA 7(a) loan underwriting.

Understanding EBITDA and Free Cash Flow

EBITDA, a non-GAAP metric, assesses core profitability by excluding interest, taxes, depreciation, and amortization, standardizing earnings across varying capital structures and accounting policies. It is widely used for profitability comparisons.

Free Cash Flow (FCF) represents cash available to stakeholders after accounting for operating expenses, taxes, changes in working capital, and capital expenditures (CapEx). It reflects liquidity for operations, debt repayment, and growth, critical for SBA 7(a) underwriting.

Key Differences Between EBITDA and Free Cash Flow

1. Capital Expenditures: EBITDA excludes CapEx, which can be significant in asset-intensive businesses. FCF deducts CapEx, offering a realistic view of residual cash.
2. Working Capital Changes: EBITDA ignores working capital fluctuations (e.g., accounts receivable, inventory), which impact cash flow. FCF incorporates these changes.
3. Taxes and Interest: EBITDA excludes taxes and interest for comparability, while FCF includes them as cash outflows, essential for debt servicing analysis.

Why This Matters in SBA 7(a) Valuations

SBA 7(a) lenders must assess repayment ability using reliable cash flow estimates. While EBITDA aids normalization and market-based valuations, it is not a substitute for FCF analysis. Misusing EBITDA as FCF can distort debt service coverage ratios (DSCR) and overstate financial health.

Example: A company with $500,000 EBITDA but $200,000 in CapEx and working capital needs may have only $200,000 in FCF, significantly lowering its valuation, impacting SBA 7(a) loan feasibility.

Valuation Implications

Valuators often start with EBITDA for normalization but must reconcile to FCF for accurate valuations. The capitalization of earnings method, using FCF, is preferred for SBA 7(a) valuations due to its simplicity and stability, converting sustainable cash flows into present value with a justified capitalization rate. FCF ensures realistic assessments of viability and repayment risk, aligning with lender priorities.

Overvaluation Risk of Applying EBITDA Multiples

Applying EBITDA multiples can overstate value if a business has high CapEx, inefficient working capital, or significant debt obligations. EBITDA multiples assume earnings translate directly to cash, which is often inaccurate. This can mask liquidity or operational issues, risking inflated collateral values for SBA 7(a) loans.

In contrast, the capitalization of earnings method using FCF provides a grounded valuation, reflecting cash flow available for debt servicing. Uniform EBITDA multiples across industries can distort valuations, particularly for businesses with high CapEx or volatile working capital. Furthermore, EBITDA multiples fail to capture investable earnings, offering more support for FCF-based methods for valuing small businesses.

Flaws in EBITDA Multiples for Valuation

Many industry professional highlight EBITDA multiples’ shortcomings:

• Derived from public companies with different scales and capital access, they are less relevant for small, closely held businesses.
• Influenced by market sentiment and comparable quality, they risk misapplication in private valuations.
• EBITDA does not measure cash available for reinvestment or owners, disconnecting from true value.

Conclusion

EBITDA is useful for evaluating operational performance but inadequate as a standalone cash flow measure. For SBA 7(a) valuations, distinguishing EBITDA from FCF is essential for accurate valuations and prudent underwriting. The capitalization of earnings method, using FCF, ensures sustainable loan performance by aligning valuations with economic reality. Detailed FCF analysis protects lenders and supports responsible SBA 7(a) lending.