Your EBITDA and Tax Shields
This week we will review how to calculate your Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) and the impact of “tax shields” on the amount of income to be taxed.
Recall that your Income Statement records sales and expenses over time. The formula is:
Revenue — COGS (Cost of Goods Sold) — Operating Expenses – Nonoperating Expense (or income) — Taxes = Net Income
Let’s look at this example:
Earnings Before Interest Taxes Depreciation and Amortization
The taxes your CPA calculates will be based on the amount of taxable income you report. A tax shield is the reduction in your tax bill caused by an increase in a tax-deductible expense, usually depreciation or interest. The amount of the tax shield will be equal to your tax rate times the increase in expense. Let’s review a couple of examples of how that works:
You buy a truck for $70,000 and you expect that it will have a useful life of five years. According to the matching principle, your accountant will probably spread the cost of the equipment over five years. Depreciation is the “expensing” of a physical asset over its useful life. There are several ways that expense can be spread over the five years, but for tax purposes, your CPA will probably opt to take as much depreciation expense as soon as possible to reduce the taxes on income the business generates in the current period.
Similarly, a company that pays interest on debt financing will get an income tax deduction for the interest paid, interest is a tax-deductible expense. The interest expense will reduce the net income to be taxed. This tax advantage is a form of a subsidy that the government pays companies that encourages the use of debt financing.
Would you like to discuss what a buyer would like to see in your financial results? Do you have a solid understanding of how revenue and expenses are recognized in your company? Thinking about how your company can maximize its value? We’d be happy to have a confidential complimentary conversation with you about these or any other exit/sales/buying issues.
You can reach me via email: [email protected] or on my cell phone a: 224-688-8838.
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Definitions:
Amortization
The gradual reduction in the value of an asset (or a debt) over time. A debt (such as a mortgage) is amortized via regular repayments. Companies use amortization to steadily reduce the value intangible assets like a patent, intellectual property, or your brand) on their balance-sheets. The same basic idea as depreciation.
Depreciation
The gradual reduction in the value of a long-lived asset from use or obsolescence. The decline is recognized in accounting by a periodic allocation of the original cost of the asset to current operations.
