- EBITDA is an acronym for “earnings before interest, taxes, depreciation and amortization.”
- EBITDA is a helpful formula for companies with long-term growth potential looking for investors, and it’s also an accurate way to compare one business to another.
- EBITDA can be misused to make a company’s earnings appear greater than they really are.
- This article is for business owners looking to use EBITDA to understand their company’s profitability or possible growth opportunities.
EBITDA, or earnings before interest, taxes, depreciation and amortization, is a valuable way to measure a company’s financial health and ability to generate cash flow. When business owners understand and apply EBITDA, they can uncover their business’s value while assessing their company’s performance. [Related article: Cash Flow Strategies for Survival]
We’ll explore EBITDA, how it’s used, and its components to help you understand and utilize this valuable analysis tool.
What is EBITDA?
EBITDA is a business analysis metric developed in the 1970s by John C. Malone, the former president and CEO of cable and media giant Tele-Communications Inc. With this formula, you can project a company’s long-term profitability and gauge its ability to repay future financing.
EBITDA can also generate valuable comparisons between different companies and industries. If you want to sell your business or court new investors, calculating your EBITDA can help you identify your company’s financial health or determine its valuation.
There are limits to EBITDA’s usefulness, however, making it crucial to understand the circumstances under which this metric can be helpful.
How is EBITDA used?
When calculating EBITDA, you’re measuring your company’s net income with costs associated with interest expenses, taxes, depreciation and amortization added back in.
Analyzing a company’s financial health using EBITDA became popular in the 1980s at the height of the leveraged buyout 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 used to do the following:
- Determine DSCR. Bankers commonly use EBITDA to determine a company’s debt service coverage ratio (DSCR). This is a type of debt-to-income ratio, specifically used for business loans, 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.” [Related article: How to Choose a Small Business Loan]
- Compare companies. Investors and business owners use EBITDA to compare companies within the same industry. “Many financial professionals, myself included, recommended using the EBITDA to compare the values of similar companies,” said Wade Schlosser, founder and CEO of Solvable. The formula can also be used to standardize business performance against industry averages.
- Give an overall view of performance. EBITDA formula advocates say it provides a fairer view of how well a business is performing. 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 business expense of developing sophisticated software when communicating with investors. [Learn which business expenses you should track.]
When to use EBITDA
“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.”
When you’re comparing the profitability of one business to another, EBITDA can help you calculate a business’s cash flow. If a company’s EBITDA is negative, it has poor cash flow.
Still, a positive EBITDA doesn’t automatically mean a business has high profitability. When comparing your business to a company with an adjusted EBITDA, it’s important to note which factors might be excluded from the balance sheet. Your goal is to make an apples-to-apples comparison to obtain an accurate analysis. Make sure you have all of that information before making any conclusions about the data.
EBITDA is useful in the following business activities.
- Budgeting: Say you’re planning your company’s budget for the next year and want to know if you can absorb the cost of upgraded machinery. With the EBITDA, you’ll have a good sense of your company’s financial health and will know if it’s the right time to add the extra expense.
- Downsizing: If downsizing staff seems necessary, but you’re debating letting employees go or trying to weather the storm, an EBITDA analysis will help you make that decision objectively, not subjectively.
- Investing: Say you have your eye on a company and are considering becoming an investor. The EBITDA can help you understand whether or not the company has strong growth potential, particularly when compared to other companies, so you can decide if joining the team is worthwhile.
- Forming an exit strategy: If you’re ready to move on from your business and would like to put your company on the market, an EBITDA analysis can prove to buyers that it’s a smart purchase and help you set the correct asking price.
Did you know?: EBITDA is just one way to measure profitability and determine your business’s worth. Instead of using it as a stand-alone metric, incorporate multiple accounting methods to get the complete picture.
What are the components of EBITDA?
To make proper use of EBITDA, you need to understand each component of the formula.
- Earnings: Earnings are what your company brings in over a certain period. To determine this EBITDA component, subtract operating expenses from your total revenue.
- Interest: An interest expense 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 are paid. 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 and amortization are added back to operating profit.
Did you know?: EBITDA doesn’t consider key elements that can factor into a company’s financial health, including intellectual property, such as copyrights and patents that might expire, and assets like expensive machines and tools that lose value over time.
What is the EBITDA formula?
Once you have numbers for each component, you can calculate your business’s EBITDA. The formula looks like this:
Revenue – expenses (excluding tax, interest, depreciation and amortization) = EBITDA
In other words, EBITDA equals net income plus interest, taxes, depreciation and amortization expenses.
Ron Auerbach, a professor at City University of Seattle, provided an example. Let’s say company A has the following financial information.
- Net income: $1.8 million
- Interest paid: $260,000
- Depreciation: $180,300
- Amortization: None
- Taxes paid: $132,500
If you’re starting your EBITDA calculation with your net income instead of revenue, you would use this formula:
Net income + taxes + depreciation + amortization + interest = EBITDA
$1.8 million + $132,500 + $180,300 + $260,000 = $2,372,800
The EBITDA would be $2,372,800.
If your accounting software doesn’t include an EBITDA report option and you’d rather not calculate it from scratch, you can use an online template. Check out the following links to get started:
If you’d rather not use an online template, learn how to choose the best accounting software to report your EBITDA for you.
Arguments against EBITDA
Many companies do not use EBITDA as a measurement, as it is not one of the generally accepted accounting principles (GAAP). GAAP rules apply when companies release a financial statement to shareholders or other external sources.
Critics cite several other reasons why EBITDA isn’t the best tool to measure a company’s financial health:
- EBITDA calculations can be deceptive. While some find EBITDA a realistic performance measurement, others believe the calculations can be deceptive and not truly representative of a company’s profitability. Critics say companies can use EBITDA to obscure warning signs, such as high levels of debt, escalating expenses and lack of profitability. EBITDA is not inherently deceitful, though, nor is it the final word on a company’s financial well-being.
- EBITDA doesn’t account for changes in working capital. The main argument against EBITDA is that it doesn’t 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 tends to signal 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 for which that business must account. 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 be manipulated. 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.
More on misusing EBITDA
The reason why a company uses EBITDA is a crucial indicator of 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. EBITDA is also effective for comparing a business against competitors, industry trends and macroeconomic trends. But if a struggling business suddenly starts relying on EBITDA when it never has before, the formula is likely not being used appropriately.
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. [Related article: When Should You Hire a CPA?]
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.
FYI: The best accounting software can help you measure EBITDA and other performance and profitability indicators.
What is an EBITDA margin?
An 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 ÷ total revenue = EBITDA margin
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.
What is a good EBITDA?
An EBITDA over 10 is considered good. Over the last several years, the EBITDA has ranged between 11 and 14 for the S&P 500. You may also look at other businesses in your industry and their reported EBITDA as a way to see how your company is measuring up.
Why is EBITDA important?
EBITDA is an effective tool when used correctly and in conjunction with other accounting metrics. It can help business owners and associates make wise decisions about their company’s direction. Prospective investors and buyers who want to know more about a company’s future profitability will find it helpful; this metric makes it easier to compare two or more companies in the same industry.
With EBITDA, all parties can have a deeper understanding of how the company might be expected to perform in the short and long term.
Erica Sandberg, Adam Uzialko and Katherine Arline contributed to the writing and reporting in this article. Source interviews were conducted for a previous version of this article.