- 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.
If you're interested in selling your business, courting investors or just painting a more accurate picture of your company's financial health, EBITDA could be the accounting technique you need.
What is EBITDA? It stands for "earnings before interest, taxes, depreciation and amortization." EBITDA allows analysts to generate useful comparisons between companies, project long-term profitability and gauge a company's ability to pay off future financing.
Joseph Ferriolo of Wise Business Plans said a healthy EBITDA calculation can help cinch the deal if you are interested in selling or merging your company.
"EBITDA is one of if not the most important measures that investors consider when a company is being bought or sold," Ferriolo told Business News Daily. "If I was going to invest, my primary concern would be ensuring that the business had an audited, up-to-date EBITDA analysis."
Financial analysts can use an EBITDA calculation to gauge the health of a company, determine a business valuation or determine whether a company can pay off long-term debt.
How is EBITDA used?
EBITDA measures a company's net income with costs associated with interest, taxes, depreciation and amortization added back. 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 to determine whether a business could afford to pay back the interest associated with restructuring.
Today, EBITDA is largely used to compare companies against one another. It can also be used to standardize business performance against industry averages. Advocates of EBITDA say that the formula 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.
EBITDA is not inherently deceitful, of course. For some companies, EBITDA provides a clearer picture of 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.
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The components of EBITDA
To make proper use of EBITDA, it's important to understand what each component of the formula means.
- Earnings: Earnings is simply what your company brings in over a certain period of time. To determine this component of EBITDA, merely subtract your operating expenses from your total revenue.
- Interest: Interest, 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. Amortization expenses are related to the eventual expiration of intangible assets, like patents. In EBITDA, depreciation as well as amortization are added back to operating profit.
Once you have each of these numbers in hand, 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.
Not every company relies on EBITDA, as it is not one of the generally accepted accounting principles. GAAP rules apply when companies release financial statements 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.]
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 EBITDA as a performance indicator is that it does not account for changes in working capital. This indication of the company's liquidity fluctuates due to interest, taxes and capital expenditures. While a negative EBITDA value may indicate that the business has trouble with profitability, a positive value may not be 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 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.
What is EBITDA margin?
One accounting method to calculate a more realistic profit picture for a company is an EBITDA margin. To determine EBITDA margin, a business must first calculate its EBITDA and then divide that number by total revenue:
EBITDA margin = EBITDA ÷ Total revenue
The EBITDA margin shows how much operating expenses are eating into a company's profits. 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 a tool to make your business appear healthier than it truly is.
Additional reporting by Katherine Arline and Chad Brooks. Some source interviews were conducted for a previous version of this article.