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What Is EBITDA?: The Essential Guide

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As a small business owner, your two biggest financial concerns are likely total revenue and net income. The former tells you how much money you’re bringing in, and the latter means how much profit you’re making. No wonder these are the top and bottom lines of an income statement.

But there are other important metrics you need to know, especially when it comes to financial planning. EBITDA is one of the most valuable business metrics you should know. EBITDA stands for earnings before interest, taxes, depreciation, and amortization.

EBITDA allows you to see how your business is performing over operating costs. Taxes, interest, intangible assets, and non-cash expenses fluctuate from company to company. EBITDA ignores those individual differences to compare how different companies perform in the same industry.

Investors and lending institutions often use an EBITDA analysis when evaluating a company or loan request. As such, EBITDA can help you understand your company’s financial performance and how other parties perceive your company.

If you want to know about using EBITDA, we can help with answers to these questions:

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    What is EBITDA?

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    EBITDA is a business analysis metric used to evaluate a company’s financial health and long-term profitability. The acronym stands for earnings before interest, taxes, depreciation, and amortization. It helps accounting professionals understand the effects of a company’s capital structure on the bottom line.

    It was initially developed by investor and Liberty Media Chair John Malone in the 1970s, and it became popular during the Leveraged Buyouts of the 1980s. Since buyouts often change a company’s debt and tax structure, EBITDA gives a more accurate look at long-term growth than a company’s net income.

    Today, business analysts use EBITDA because every company has different debt and tax structures. EBITDA helps investors, business owners, and lenders look at a company’s cash profit potential by stripping away the expenses related to interest, taxes, depreciation, and amortization.

    What are the Components of EBITDA?

    You can find the information you need for EBITDA analysis on cash flow and income statements. Let’s break down the individual parts of EBITDA.

    Earnings

    Earnings, or net income, are found on the bottom line of your income statement. It’s your company’s profit after accounting for all business expenses.

    Interest Expenses

    Interest expenses include the costs of servicing debt. Interest payments are usually included on a company’s income statement.

    Tax Expenses

    Your tax expenses include any federal, state, or local taxes your company has to pay. Companies in the same industry but in different areas will have different tax structures. Removing tax expenses helps compare companies.

    Depreciation and Amortization

    Depreciation is a non-cash expense representing the declining value of tangible assets like business equipment, office furniture, etc. Amortization expenses refer to the eventual loss in value or expiration of intangible assets such as a patent or proprietary software. Depreciation and amortization are typically found on a company’s cash flow statement.

    In essence, EBITDA equals net income plus interest, taxes, depreciation, and amortization expense.

    How do you Calculate EBITDA?

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    Calculating EBITDA is straightforward. You take your net income and add your interest, taxes, depreciation, and amortization expenses. You can use two formulas to find a company’s EBITDA: net income or operational profit.

    Net Income EBITDA Formula

    To perform a net income EBITDA calculation, you start with your net profit and then add each component back in:

    EBITDA = Net income + Interest + Taxes + Depreciation + Amortization

    Operating Profit EBITDA Formula

    Your operating profit, or operating income, is how money is left over after subtracting your company’s operating expenses. Operating profit already includes taxes and interest, which simplifies the formula. Using an operational profit EBITDA calculation looks like this:

    EBITDA = Operating profit + Depreciation + Amortization.

    Example EBITDA

    Let’s say your company made $1,000,000 in revenue. Your cost of goods sold equals $300,000, and your overhead is $400,000. Then you have $100,000 in depreciation and amortization, $50,000 in interest, and $50,000 in taxes, leaving you with a net income of $100,000. Your EBITDA would be:

    Earnings:                                   $100,000
    Depreciation Amortization:    $100,000
    Interest Expense:                    $50,000
    Taxes:                                     $50,000

    EBITDA =                              $300,000

    How do Companies use EBITDA?

    You can use EBITDA to analyze your company when making budgeting decisions or trying to sell the business. Investors and lenders sometimes use EBITDA when deciding to invest, buy a company, or approve financing.

    Business Valuations & Cash Flow

    EBITDA is a valuable metric when analyzing a company’s financials. While it can’t determine a company’s value on its own, it can help give a holistic picture of the overall value. In addition, EBITDA analysis helps showcase a company’s profitability and cash flow.

    Comparing Companies

    It can be challenging to compare two companies in an industry. Different capital and tax structures obscure profit potential. With an EBITDA analysis, investors and other interested parties can look at each company’s profit after operating expenses.

    Determining DSCR & Financing Decisions

    Bankers and lending institutions may use EBITDA to determine a company’s debt service coverage ratio (DSCR). DSCR is a type of debt-to-income ratio explicitly used for business financing that measures a company’s ability to repay a loan.

    Understanding and improving your EBITDA is one way to help you improve your chances of credit approval when applying for a business loan. It helps you look at your company the same a potential lender might.

    Frequently Asked Questions

    Here are some of the most common questions about EBITDA.

    What are EBITDA Variations?

    Businesses use several variations of EBITDA to analyze a company’s operating performance. Remember that EBITDA is just one metric for a business’s financial performance. You should always use a combination of metrics along with EBITDA for a complete picture.

    The following variations are often used:

    • EBIT: Earnings before income and taxes. This metric doesn’t add the depreciation and amortization expenses. It is also known as operating profit or operating income.
    • EBIAT: Earnings before interest after taxes. This formula looks at a company’s earnings after taxes and before interest payments.
    • EBITDAR: This formula expands on EBITDA by adding rent or restructuring expenses to the equation.
    • Adjusted EBITDA: Removes one-time and irregular expenses to normalize a standard EBITDA measuring only fixed assets.

    What is a Good EBITDA?

    There is no hard and fast rule or simple dividing line between a good or bad EBITDA. A negative EBITDA means poor cash flow. But a positive EBITDA doesn’t necessarily mean strong financial health.

    EBITDA is most useful as a comparison against industry benchmarks or your own goals. You can compare your company’s performance against competitors if you know their EBITDA.

    A more helpful metric is the EBITDA margin.

    What is an EBITDA Margin?

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    An EBITDA margin is an accounting method that calculates profitability as a percentage. When calculating an EBITDA margin, you first find the EBITDA. Then divide that by total revenue and convert the quotient into a percentage.

    EBITDA margin formula:

    EBITDA ÷ total revenue = EBIDTA margin.

    Let’s say a company has an EBITDA of $450,000 on $3,000,000 in total revenue. The formula would look like this:

    $450,000 ÷ $3,000,000 = 0.15, which becomes 15%

    Let’s look at how EBITDA margins create a better comparison than EBITDA alone.

    Company A has a gross revenue of $2,000,000 with an EBITDA of $200,000.

    Company B has a gross revenue of $1,500,000 with an EBITDA of $175,000.

    It might appear Company A is more profitable. However, when we run the EBITDA margins, we see the following:

    Company A: $200,000 ÷ $2,000,000 = 10% EBITDA margin.

    Company B: $150,000 ÷ $1,500,000 = 12% EBITDA margin.

    When we look at the percentage, Company B has a higher profit margin and is likely the better investment.

    A good EBITDA margin is 10% or greater. Most S&P 500 companies have an EBITDA margin between 10%-14%.

    Why is EBITDA important?

    EBITDA can help you analyze your company’s financial health, evaluate your cash flow, and help determine long-term profitability. Remember that while EBITDA is a valuable metric, you shouldn’t rely solely on it. It should help you look at your financial strength but should include other metrics as well. In addition, the EBITDA margin helps give you a specific percentage for valuation.

    Let’s review some situations where you can use EBITDA analysis to help make a business decision.

    Business Finance Budgeting

    Imagine your company is considering a new equipment upgrade in the next year. You want to ensure you can absorb the debt payments before committing to equipment financing. You can use an EBITDA analysis to determine if your company is in a strong enough position for the additional funding.

    Downsizing Decisions

    No one wants to face a downsizing situation. For a lot of business owners, it can be an emotional decision. You need to do what’s right for your business but don’t want to let people go if you can afford to keep them on staff.

    With EBITDA analysis, you can get an objective metric to help you make your decision. If your EBITDA or margin is high, you’ll likely be able to hold off on downsizing; but it might be necessary if your analysis shows ongoing profit concerns.

    Investing and Acquisitions

    Maybe you’re considering investing in a company. Or perhaps your company wants to absorb a competitor for you to expand, but you need to ensure the new acquisition won’t become a loss.

    Running an EBITDA analysis on the target company can help you identify its growth potential, particularly when comparing them to other companies in the respective industry. You can make an informed decision on investing or acquiring a company.

    When It’s Time to Sell

    Maybe you’re about to retire and want to sell your company for a nice nest egg. Or perhaps the market conditions make it an ideal time to sell. Whatever your reasons, when you want to sell your company, EBITDA can help attract potential buyers.

    What are the concerns with EBITDA?

    While EBITDA is helpful in business analysis, it is not accepted by all. For example, Warren Buffet doesn’t consider EBITDA an adequate measure of financial performance.

    One of the most important things to note is that EBITDA is not a generally accepted accounting principle (GAAP). Companies must follow GAAP rules when releasing financial statements to their shareholders or external parties. Some companies do include EBITDA and adjusted EBITDA in their quarterly results. The Securities and Exchange Commission (SEC) requires companies reporting EBITDA to include how they arrived at their data.

    Another common concern is the claim that EBITDA reports are sometimes deceptive and inflate a company’s value. After all, capital expenditures are actual expenses. EBITDA can also obscure warning signs such as high debt levels, increasing costs, and a lack of profitability.

    Furthermore, EBITDA data is vulnerable to manipulation and can hide a company’s actual ability to pay off debt. Companies can also alter depreciation schedules to make it look like they’re more profitable than they really are.

    When used in good faith, EBITDA can help compare a business against other companies, macroeconomic trends, and industry averages. However, some companies can try to inflate their value. A potential warning sign is if a struggling company suddenly starts using EBITDA when it never has before.

    Let’s examine some of the pros and cons of using EBITDA analysis.

    EBIDTA Pros and Cons

    Pros:

    • Calculates a better view of actual business health compared to the business model.
    • Removes the variables of capital investment and financing expense.
    • It only accounts for the operating costs of running the business.
    • It showcases how ongoing operations generate cash flow.
    • A good indicator of how well the business produces profits.
    • Excellent for comparing two companies in the same industry.
    • It helps give an idea of long-term growth and profitability.

    Cons:

    • Not a generally accepted accounting principle (GAAP).
    • Does not account for changes in working capital.
    • Can hide or obscure a significant tax or interest burden.
    • Unscrupulous companies can manipulate data to inflate valuation.

    EBITDA – Final Thoughts

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    EBITDA is a valuable tool to help you evaluate your business’s financial health and plan for future investments or expenses. It is not without its limitations and concerns, though.

    One of the most valuable purposes of EBITDA is to help determine your capacity to support business financing, and it also helps compare competing companies within an industry. By eliminating the individual factors of tax and capital structures, you get a solid look at a profit over operating expenses.

    When using EBITDA, make it one of your metrics to evaluate performance. Do not rely solely on EBITDA. When analyzing another company’s EBITDA report, check their financial statements on how they arrived at their numbers. The SEC mandates companies reporting EBITDA to include an explanation for the amount.

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