As a business owner, it is crucial to have a complete overview of all the business operations. This is because how the business grows, in the long run, determines its overall value.
Of course, not to mention the other factors that affect the company’s profitability and company’s financial performance, such as cash flow, net income, operating expenses, amortization expenses, and others.
Oftentimes, investors and business owners view the net income, revenue, and cash flow as the focal points in measuring their company’s profitability, financial health, and value.
However, another business metric has acquired traction for quarterly reports and accounts in recent years.
This measure is known as EBITDA. Primarily utilized to analyze and compare a company’s profitability between different businesses within the industry.
Understanding EBITDA: What every beginner should know!
When we talk about EBITDA, we simply pertain to the net income or earnings with added interest, taxes, depreciation, and amortization expense. It is mainly used to analyze and compare companies as it eradicates the impacts of financing and capital expenditures.
EBITDA definition
So what is EBITDA?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a metric employed to evaluate a business’s operating performance. The concept started out in the 1970s by the former president and CEO of a renowned tech giant Tele-Communications INC.
With this formula, you can project the long-term financial performance, profitability, ability to sustain, and a healthy debt financing capability.
Many find EBITDA as a valuable metric to understand a company’s ability to generate cash flows and its operating profit and performance.
By using EBITDA, you have an accurate measure and comparison of businesses through a number of different elements. Despite its limitations, EBITDA can be very vital in helping identify when it can be valuable.
However, EBITDA calculation is not a recognized measure by the International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP). Thus, many financial analysts detract from the use of the EBITDA calculation.
How is the EBITDA used today?
Despite arguments raised by the use of EBITDA among financial analysts, a lot of businesses and investors still value the data they can yield from the calculation for a lot of reasons. Today, the EBITDA is used for the following:
Determine the Debt Service Coverage Ratio (DSCR)
Many workers in the banking industry use the EBITDA to determine a business’s cash flow and its ability to pay company debt.
Compare two companies
The EBITDA can be helpful in comparing companies in the same industry. However, the formula is seen to be primarily valuable for standardizing company performance against the industry averages.
Give an overall perspective on performance
Those that use the EBITDA formula campaign that it provides a fair view of the company’s financial health and how well it performs. It enables companies to provide a clearer picture of how they will likely turn out in the long run. As an example, tech companies prefer using EBITDA to disregard upfront business expenses such as in the process of developing the software when communicating with other expenses.
How to Carry Out EBITDA Calculation
Before understanding the EBITDA formula, you first have to have an idea of what elements it is comprised of.
Earnings
Earnings are considered the amount of income that your company accumulates over a period of time. In determining earnings, subtract the operating expenses from the company’s total revenue.
Interest
Interest expenses pertain to the cost of servicing debt. It may also represent interest earnings. However, it is generally referred to as an expense. In EBITDA calculation, the costs linked with interests are not deducted from earnings.
Basically, interest expenses are excluded from a company’s EBITDA as this expense highly depends on the structure of finance of a company. These business expenses come from the company’s borrowed funds in order to finance its operational and organizational activities.
Different companies consist of varying capital expenditures that result in different interest expenses. Therefore, it becomes easier to compare different companies by adding the interest back while disregarding the impact of capital structures on the business.
Take note, that taxes can be deducted from interest payments which means that corporations can shield from this advantage known as a corporate tax shield. Check out the detailed guide to sales budget.
Taxes
Tax expense is caused by tax rates imposed by the city, state, and country. In EBITDA calculation, earnings before interest and taxes are also known as the company’s operating profit which is displayed as EBIT.
Taxes vary on the place where the business is located. This does not directly impact in assessment of a company’s operating performance and management. Therefore, a lot of financial analysts and accountants use them to compare companies.
Depreciation and Amortization
Depreciation and amortization expenses rely on the investments that a company has done in the past and not on the current operating performance. Many companies invest in fixed assets such as buildings, vehicles, and spaces that may lose their value due to weathering and damage.
The depreciation expense is primarily based on a chunk of tangible assets that deteriorate over time. Amortization expense, on the other hand, is acquired for intangible assets. Significant intangible assets like patents, trademarks, and computer software are amortized because of their limited life extent before expiration.
Depreciation and amortization expense are heavily affected by economic life and the depreciation method used. Due to this, financial analysts suggest that D&A be pushed back from the EBITDA calculation.
The depreciation and amortization expenses maybe can be found in the financial cash flow. Since depreciation and amortization expense are non-cash expenses, it is added back to the cash flow statement. Check out the guide about sales incentives.
The EBITDA formula
There are two primary ways that you can calculate EBITDA. The first utilizes the operating income as its starting point, while the second uses the net income.
As mentioned, the EBITDA calculation paved the way for analyzing distressed and unprofitable companies in the 1980s. The EBITDA calculation was helpful in analyzing whether these unprofitable companies can pay back their interest expense and continued to be a useful tool in determining a company’s financial health.
Let us look at the two EBITDA formula.
The Two EBITDA formula
Using the Operating Income as Starting Point
You may execute the EBITDA calculation using the formula below:
EBITDA = Operating income + Depreciation and Amortization
A company’s operating income is the profit once the operating expenses are deducted. The operating income helps out business owners and investors separate the company earnings by excluding interest expenses and taxes. Thus, as its name suggests, it shows the money that a business can earn from its daily operations.
Operating income is calculated as the sales with operating expenses deducted which includes the employee wage and cost of goods sold (COGS).
Operating income can be determined right before the interest and taxes are taken out. Therefore, only the depreciation and amortization expense are only the ones added to compute the EBITDA.
Note that the depreciation and amortization expense is often included within the operating expenses on the income statements. Therefore, the value of depreciation and amortization expense is often found under cash flows from operating activities, as stated in the cash flow statement.
Using the Net Income as Starting Point
Here is the second formula for calculating EBITDA using the net income:
EBITDA = Net Income + Taxes + Interest Expense + Depreciation and Amortization
Unlike the previous formula, this formula begins with the use of net income and adds the taxes and interest expenses to get the operating income. Like the values of operating income, the net income tax expense, and interest expense are all found in the income statement.
It is important to take note that these two EBITDA calculations can result in different values as the net income consists of some items which may not be included in operating income, such as non-operating profit or one-time expenses.
In a nutshell, the EBITDA represents the net income or net loss before the interest expense, income tax expenses, depreciation, and amortization.
On the other hand, there is also what we call the Adjusted EBITDA.
So what is the adjusted EBITDA?
The adjusted EBITDA is defined as the EBITDA that is modified to make an impact on certain items which are required for the calculation.
Although the difference between the two concepts is minimal, they are important to understand. With standardized cash flows and income, while removing any extraneous variables, the adjusted EBIDTA enables companies to analyze different companies simultaneously, disregarding factors such as industry variances, and geography, among others.
To calculate adjusted EBITDA, subtract or add to the EBITDA formula the income and expenses. However, both do not represent the net income and free cash flow available within the company used for capital expenditures, tax payments, and debt service requirements.
The adjusted EBITDA may include the following adjustments:
- Salary: Adjustments in the salaries are made to also account for the owner’s salary which can be higher or below the market rates.
- Perks and Benefits: Perks of owners are added to the EBITDA calculation, such as personal expenses, and business or travel expenses which can include club membership fees, meals, and entertainment expenses.
- Professional Fees: Professional fees which may be one-time such as lawyer fees are added back into the equation.
- Rent: Any rent fees which are higher or below the market rates are included.
The use of the adjusted EBITDA is mostly common for businesses in the lower middle market. These businesses may be sole proprietor-owned which makes the business to be the significant payer of some personal benefits of the owner alongside their beneficiaries such as their families or their chosen benefactors. Find the detailed guide about sales to revenue management.
Benefits and Disadvantages of EBITDA in Businesses
The EBITDA is a widely-used business metric. As it presents its significance to business owners and financial analysts alike, there are also some avenues that can lead to its misuse, resulting in negative effects in the process.
Benefits of EBITDA
1. It is widely used
As many business owners in the same industry value the use of EBITDA, it has become a very common formula for many groups and investors. Thus, making it a familiar formula to work with making it easier to conduct comparisons between a company’s performance and enterprise value, and even compare profitability.
2. It removes extraneous variables
Removing extraneous variables such as interest rates, tax rates, depreciation and amortization expense which vary from business to business, a business can have a clearer picture of a company’s operating performance.
3. It is easy to carry out
All EBITDA formulas are easy to execute as they are quick and straightforward to do as long as your financial data are accurately encoded. This way, you can easily have an understanding of all angles of your financial statements and estimated valuation range.
Disadvantages of EBITDA
Although EBITDA has shown its most significant advantage in its focus on calculating earnings and determining profitability by excluding capital expenditure, some analysts also think of it as its primary weakness.
Why?
Because for many, unlike other metrics, the disregard for expenditures can allow companies to overthrow problem areas that can make unethical changes in their financial statements. Because of its straightforward nature and the information that it diminishes, a business can obscure some risks that can, later on, have an impact on the overall company’s performance.
Another common misconception is that EBITDA can represent cash earnings. However, this formula ignores the cost of capital assets and assumes that a business can be profitable by focusing on sales operating profit.
No matter what a company’s capital structure has, it is important to categorize capital expenses. However, the EBITDA formula leaves out the cash required to fund and replace the working capital assets.
Because of its remarkable flexibility, the computation of earnings before interest, taxes depreciation, and amortization can start through different earning figures. Therefore, making it susceptible to calculate earnings which can remain unreliable.
Another is that EBITDA, unlike other metrics, does not fall under Generally Accepted Accounting Principles (GAAP), which means that it becomes a company’s prerogative on how they would want to interpret the formula and adjust its components according to their benefit.
This flexibility can help remove and undermine red flags that may affect the experience of prospective clients.
Therefore, it is a must that you only work with trusted financial analysts to ensure that you do not misuse the flexibility and work your way around using the EBITDA calculation.
With this, you can have a clear and accurate idea of what values can be eliminated from the formula while ensuring that there is nothing that can cause any problem for your business in the long run which can lead to broken trust and waste of time and funds.
Common questions about EBITDA
Is EBITDA the same as Net Profit?
Technically, EBITDA is used as a measure of profit, but the net profit requires removing interest, taxes, depreciation and amortization. It is a better substitute for gross profit than net profit.
How do EBITDA and Gross Profit differ from each other?
When talking about gross profit, we talk about the number of earnings that is the profit after the production costs are considered. To calculate the gross profit, here is the formula below:
Gross Profit = Revenue – Cost of Goods Sold
The gross profit takes into consideration the cost of goods sold or all the expenses connected to the selling of the product or service to the consumers. It does not include the costs and expenses such as tax and interest.
Both the formulas can yield the earnings of the company. However, the company profit can be calculated in different ways.
The bottom line is that both formulas are useful for any business. However, the EBITDA presents profitability before interest payments, taxes, depreciation and amortization.
What is the difference between the EBITDA margin and the profit margin?
The net profit margin is one of the most vital indicators of a company’s financial health. This is calculated by the following formula:
Net Profit Margin = (Revenue – Cost of Goods Sold – Operating Expenses – Other Expenses – Interest – Taxes) / Revenue x 100
Through this formula, one can have a clearer picture of how a company can generate cash flow through every sale. On the other hand, EBITDA accounts for all expenses generated such as production and operating expenses but includes both the depreciation expense and amortization expense.
How do cash flow and EBITDA differ from each other?
Cash flow and EBITDA are two ways that a company’s profit and value can be assessed. While calculating EBITDA can present the company’s potential for earning right after the tax expense, interest expense, depreciation expense, and amortization expense are removed, the free cash flow remains unrestrained. Instead, it takes the company’s earnings and modifies them by adding the depreciation and amortization expense, then deducts the working capital adjustments and expenses.
Both of these measures help in determining the business value and cash profit.
What activities will EBITDA be useful for?
Budget Planning
With an accurate calculated EBITDA, you can have a great view of your company’s financial health through an accurate report of your company’s income statement. Therefore, it becomes handy when you are planning your budget for the upcoming year. It becomes easier to make strategic decisions as you have other angles which you can look into.
Cutting Down Staff or Expenses
If at any point in your business, cutting down expenses or downsizing staff becomes needed, analyzing your options through EBITDA can help you create a sound decision that is objective. Any decision which you will make is backed up by data that enables you to weigh out what is best for your company in the long run.
Investment
As the EBITDA can help you have an in-depth understanding of the degree to which a company can earn, you can have a clearer picture of its growth potential. Therefore, it can be crucial for business owners, private equity investors, and stakeholders to have a reliable basis from which they will make their decisions. With great EBITDA data, you can be sure that a company is worth the investment because of its enterprise value.
Forming a selling strategy
Once you decide to sell out your company and would want to make it stand out in the market, an EBITDA analysis can lay a strong foundation to entice buyers to purchase your company. This allows you to have a strong and reasonable asking price given its enterprise value accurately shown through your analysis.
How does EBITDA help boost your company identity and image?
The use of EBITDA for many companies has helped them set a strong foundation in the market. This allows investors, buyers, private equity investors, and financial analysts to see the underlying value and company profitability.
Being a useful measure to gauge and compare profitability, it becomes easier to compare earnings between two companies by removing the effects of financing, taxes, and other accounting elements.
As accounting techniques and capital structure still vary in business operations, it still is essential in the discussion of business value.
Conclusion
EBITDA is indeed a very simple business measure that can be very useful for some complex accounting tasks such as understanding and determining business values. Its immense effect on financial analysis has become crucial which makes it valuable in the business world.
Using a company’s EBITDA calculations can provide a clearer picture of the company’s cash flow and spearhead meaningful data analysis including the comparison between competing businesses.
Whether a business is capable of earning or not, the EBITDA remains a useful approach to provide that valuable information making it easier for further analysis and business planning.
Despite its drawbacks, the EBITDA remains an effective tool when used accurately and in affiliation with other accounting metrics. Making wise and sound decisions backed up by reliable solutions can help determine the company’s long-term directions.
Through EBITDA, prospective investors and buyers can have a grasp of a company’s financial capability and profitability.
It is important to take note that certain accounting techniques and approaches are useful in optimizing EBITDA to make results more attractive.
Therefore, in order to build a strong foundation for your company’s identity, having a single source of information can be improved by using other tools and metrics to build a clearer picture of your company’s financial health and overall value. Check out the guide about the fiscal year.