EBITDA is a way to measure a company's financial health. Here's how you can use this analysis tool.
- EBITDA is an acronym for "earnings before interest, taxes, depreciation and amortization."
- It's a useful formula for companies with long-term growth potential that are looking for investors, or as an accurate way to compare one business to another.
- It can be misused to make a company's earnings appear greater than they really are.
- This article is for business owners looking to understand their company's profitability or possible growth opportunities.
EBITDA is an analysis formula that stands for "earnings before interest, taxes, depreciation and amortization." It allows analysts to generate useful comparisons between companies, project a company's long-term profitability and gauge its ability to pay off future financing. If you're interested in selling your business or courting investors, calculating your EBITDA can help you gauge the health of your company or determine your business's valuation.
How is EBITDA used?
It's important to understand how EBITDA applies to your business. When calculating EBITDA, you're measuring your company's net income, with costs associated with interest expense, taxes, depreciation and amortization added back in. Measuring a company by EBITDA first became popular in the 1980s at the height of the leveraged buyouts era. During this time, it was common for investors to financially restructure distressed companies, and EBITDA was primarily used as a yardstick of whether a business could afford to pay back the interest associated with restructuring.
Today, EBITDA is commonly used by bankers to determine your debt service coverage ratio (DSCR). This is a type of debt-to-income ratio, used specifically for business loans, that is meant to measure your cash flow and ability to pay.
"When lenders assess the risk of their loan portfolio, they break losses into two components –the probability of default and the severity of default," said Rob Stephens, CPA and founder of CFO Perspective. "This ratio measures the probability of default, which is how likely [it is that] the borrower will not be able to meet their contractual debt service obligations."
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EBITDA is also largely used to compare companies against one another. It can also be used to standardize business performance against industry averages. Advocates of the EBITDA formula say that it provides a fairer view of how well a business is performing, but critics argue it could be used to obscure warning signs, such as high levels of debt, escalating expenses or lack of profitability.
"Many financial professionals, myself included, recommended using the EBITDA to compare the values of similar companies," said Wade Schlosser, founder and CEO of Solvable.
When you're comparing the profitability of one business to another, EBITDA can help you calculate a business's cash flow. When a company's EBITDA is negative, it has poor cash flow. However, a positive EBITDA doesn't automatically mean a business has high profitability either. When comparing your business to a company with an adjusted EBITDA, take note of which factors are excluded from the balance sheet. Your goal is to make an apples-to-apples comparison for an accurate analysis. Make sure you have all of that information before making any conclusions about the data.
EBITDA is not inherently deceitful, but nor is it the final word on a company's financial state. For some companies, EBITDA provides a clearer picture of their long-term potential. Tech startups, for example, would prefer to use EBITDA to exclude the upfront expense of developing sophisticated software when communicating with investors.
"EBITDA is one of if not the most important measures that investors consider when a company is being bought or sold," said Joseph Ferriolo, director at Wise Business Plans. "If I was going to invest, my primary concern would be ensuring that the business had an audited, up-to-date EBITDA analysis."
Key takeaway: EBITDA is used to determine a company's profitability and whether the company is capable of repaying a loan. It's also a useful analysis tool for comparing your business against industry averages.
The components of EBITDA
To make proper use of EBITDA, you need to understand what each component of the formula means.
Earnings: Earnings are simply what your company brings in over a certain period of time. To determine this component of EBITDA, merely subtract the operating expense from your total revenue.
Interest: An interest expense, of course, refers to the cost of servicing debt. It can also represent interest earned, though it generally refers to an expense. In EBITDA, the costs associated with interest are not deducted from earnings.
Taxes: Only two things are certain in life – death and taxes – except when it comes to EBITDA, which measures a company's earnings before taxes. Earnings before interest and taxes is also commonly referred to as "operating profit," which can be expressed as EBIT.
- Depreciation and amortization: Depreciation represents the loss in value in tangible assets, such as machinery or vehicles, generally related to use over time. An amortization expense is related to the eventual expiration of intangible assets, like patents. In EBITDA, depreciation as well as amortization are added back to operating profit.
What is the EBITDA formula?
Once you have numbers for each of the components listed above, you can calculate your business's EBITDA. The formula itself looks like this:
EBITDA = Revenue - Expenses (excluding tax, interest, depreciation and amortization)
More simply, EBITDA equals net income plus interest, taxes, depreciation and amortization expense. Ron Auerbach, MBA professor at City University of Seattle, provided the following example.
Let's say company A has the following financial information:
- Net income – $1.8 million
- Interest paid – $260,000
- Depreciation – $180,300
- No amortization
- Taxes paid – $132,500
If you're starting your EBITDA calculation with your net income instead of revenue, you would use this formula:
EBITDA = Net income + Taxes + Depreciation + Amortization + Interest
$1.8 million + 132,500 + 180,300 + 260,000
The EBITDA would be $2,372,800.
Not every company relies on EBITDA, as it is not one of the generally accepted accounting principles. GAAP rules apply when companies release a financial statement to shareholders or other external sources. EBITDA can be an effective tool for a company with long-term growth potential to court investors or to more accurately compare one business to another. However, when a company begins using EBITDA without warning, it could be a red flag they are attempting to obscure their finances in some way. [Looking for accounting software? Check out our best picks and reviews.]
Key takeaway: To accurately calculate EBITDA, you must understand each part of the formula. You can calculate your EBITDA by finding the sum of your business's net income, taxes, depreciation, amortization and interest, which are the components of this analysis tool.
If your accounting software doesn't have an EBITDA report and you'd rather not calculate it from scratch, you can use an online template to help you. Check out the following links to get started:
Key takeaway: You can find free EBITDA templates online to help you calculate the profitability of your business.
Arguments against EBITDA
While many find EBITDA to be a good indicator of performance, others believe the calculations can be quite deceptive and not representative of a company's profitability. Like any tool, EBITDA can be used for good or ill, so it is largely up to the observer to draw their own conclusions. However, there are some long-standing criticisms of EBITDA.
The main argument against relying on an EBITDA calculation as a performance indicator is that it does not account for changes in working capital. This indication of the company's liquidity fluctuates along with interest, taxes and capital expenditures. While a negative EBITDA value does tend to indicate that the business has trouble with profitability, a positive value is not necessarily synonymous with a healthy company, because taxes and interest are actual expenses that businesses must account for. In contrast, a company may have low liquidity if its assets are difficult to convert into cash but maintain a high level of profitability.
EBITDA can also provide a distorted picture of how much money a company has available to pay off interest. When you add back depreciation and amortization, a company's earnings can appear greater than they really are. EBITDA can also be manipulated by changing depreciation schedules to inflate a company's profit projections.
The reason why a company is relying on EBITDA is an important indicator as to whether it's using the formula in good faith. Startups, especially those that require heavy upfront investment to realize future growth, are likely to use EBITDA for good reasons. It is also effective for comparing a business against competitors, industry trends and macroeconomic trends. If a struggling business suddenly starts relying on EBITDA when it never has before, however, the formula is likely not being used appropriately.
Key takeaway: EBITDA can be a helpful resource, but remember that it doesn't account for changes in working capital and isn't the final word on a business's financial health. You should not manipulate the EBITDA formula for dishonest purposes like making your business look better financially than it is.
What is an EBITDA margin?
One accounting method to calculate a more realistic profit picture for a company is an EBITDA margin. To determine your business's EBITDA margin, you must first calculate its EBITDA and then divide that number by total revenue:
EBITDA margin = EBITDA ÷ Total revenue
For example, let's say company A has an EBITDA of $500,000 along with a total revenue of $5 million.
$500,000 ÷ $5,000,000 = 10%
The total EBITDA margin will be around 10%.
The EBITDA margin shows how much operating expenses are eating into a company's gross profit. In the end, the higher the EBITDA margin, the less risky a company is considered financially.
No matter how you slice and dice your company's financials, honesty in dealings with investors and potential buyers is essential to preserve your professional reputation.
"The most important question for investors and analysts is to ensure that the company's financials have been recently and thoroughly audited by a CPA," Ferriolo said.
Misusing formulas like EBITDA to obscure shortcomings in your business is certain to ruin relationships and damage your brand. Always deal in good faith and use EBITDA and other financial metrics as intended, rather than as tools to make your business appear healthier than it truly is.
Key takeaway: An EBITDA margin is another way to examine your business's profitability. To assess the amount of operating expenses cutting into your profits, you would divide your EBITDA by your total revenue.
Adam Uzialko and Katherine Arline contributed to the reporting and writing in this article. Some source interviews were conducted for a previous version of this article.