EBITDA helps show how a company's core business generates earnings before certain tax, financing, and accounting decisions are considered.
- EBITDA can make it easier to compare businesses with different financing, tax, and accounting circumstances.
- Tracking EBITDA over time can help identify changes in operating efficiency and financial trends.
- EBITDA should be used alongside measures such as net income and cash flow because it does not provide a complete picture of financial health.
EBITDA is a financial metric that measures the underlying performance of a business's core operations, excluding factors it can't control. It also looks beyond specific business decisions to clarify a company's operating health. Let’s look at what EBITDA considers and how the calculations work.
What Is EBITDA?
EBITDA stands for “earnings before interest, taxes, depreciation, and amortization.” It’s a way of valuing a business without getting into specialized details like a company's debt load or which tax bracket it falls into.
Here’s how that breaks down:
- Ganancias: The company’s net profits, or the revenue earned after operating expenses
- Interés: How much the company pays in interest for any financing costs associated with the business, such as lines of credit or loans
- Impuestos: Includes federal, state, and local taxes
- Depreciación: How tangible assets such as vehicles or office equipment lose value over time
- Amortization: How intangible assets such as software or patents lose value over time
Brief History And Everyday Uses
While it has limitations in assessing a business’s total value, EBITDA can help create a clearer picture of the operating performance.
For example, let's say two companies have similar business models and sales outcomes, but one raised equity to start and the other borrowed fairly heavily. On paper, the business that used equity may look better because the company with traditional debt has a higher interest rate affecting profitability calculations. Once that debt is cleared, both businesses will likely look similar.
EBITDA can also help with:
- Comparing two businesses with different tax situations or depreciation expenses, similar to the example above with debt
- Examining the company’s underlying earnings
- Evaluating a business before or during an acquisition, since things like interest on debt may be different once the acquisition is final
- Understanding revenue over time (growing revenue but shrinking EBITDA may indicate that the business is less efficient at turning revenue into operating expenses)
How To Calculate EBITDA
There are multiple ways a financial institution or business might calculate EBITDA.
Formula 1: Net Income + Interest + Taxes + Depreciation + Amortization
The first way is to start with net income and add back expenses. This approach may work well if you’re starting from the bottom of an income statement and have net income readily available.
This is what it might look like in real life. Imagine a company’s numbers look like this:
| Financial Item: | Monto: |
|---|---|
| Ingresos netos | $500,000 |
| Gasto por interés | $75,000 |
| Impuestos | $125,000 |
| Depreciación | $60,000 |
| Amortización | $40,000 |
| EBITDA Total | $800,000 |
Using the first formula, the EBITDA would be $500,000 + $75,000 + $125,000 + $60,000 + $40,000, for a total of $800,000.
Formula 2: Operating Income + Depreciation + Amortization
In this formula, operating income is already calculated, so you only need to add back depreciation and amortization. This option may be helpful if you’re focusing more on operating performance.
Imagine a company’s numbers look like this:
| EBITDA Item | Monto: |
|---|---|
| Operating income | $500,000 |
| Depreciación | $60,000 |
| Amortización | $40,000 |
| EBITDA Total | $600,000 |
In this example, EBITDA would be $600,000 ($500,000 + $60,000 + $40,000).
What EBITDA Tells You About A Business
EBITDA helps you look at a company's underlying operations and compare performance when other factors, like taxes, are outside the business’s control.
Core Insight: Operating Profitability vs. Net Income
There are several ways to examine a company's income and profit. Net income shows what remains after a business deducts expenses from revenue. Operating profitability shows earnings from the company’s core business activities. EBITDA goes a step further by excluding other financing and accounting factors that affect the bottom line.
When and Why EBITDA Is Used
EBITDA may be useful when you need to evaluate financial performance separately from certain financing or accounting decisions. Investors might use it to compare similar businesses or as part of a company valuation.
Financial providers may look at one or more of these to clarify a company’s operations. For example, two companies with similar models may report very different net income because one also has outstanding debt it is paying down. Looking at EBITDA helps separate those differences from the business's actual performance.
Tracking it over time might also indicate when a business is improving or showing signs of trouble. It may make it clearer whether a company is generating more or less earnings as it grows.
What Does Debt Service Coverage Mean?
Debt service coverage measures a company’s ability to generate enough income to meet its debt obligations. EBITDA may be used as a starting point for assessing this capability because it excludes interest expenses. However, lenders may use more specific calculations that account for principal payments and other requirements.
Using EBITDA for Small Business Financial Analysis
Small businesses may find EBITDA more useful as an ongoing part of financial analysis rather than as a standalone number. Here's what this entails:
- Gather Financial Statements. Start with up-to-date statements that include net or operating income, along with your taxes, depreciation, and amortization numbers. Make sure you know your current, real interest numbers as well.
- Calculate EBITDA. Choose either net or operating income depending on what number you already have available. Use that same method consistently from period to period.
- Adjust For Owner And Discretionary Costs. Small businesses might also calculate an adjusted EBITDA by adding back certain unusual, nonrecurring, or discretionary expenses.
- Benchmark Against Industry Multiples. Compare with similar businesses in your industry. Multiples may vary based on factors like company size, industry, growth, risk, and market conditions, but they can provide context to the evaluation.
- Track Trends Over Time. A single figure is a snapshot. Tracking it across months or even years may reveal whether operating earnings are growing, demonstrating whether the business is becoming more or less efficient as revenue changes.
- Use Results In Decision-Making. Put EBITDA numbers in context with others like cash flow or capital expenditures.
Limitations And Best Practices For Using EBITDA
EBITDA isn’t a complete measure of profitability or financial health. Understanding what the metric excludes is important to using it well to analyze a business.
Key Limitations
There are several reasons EBITDA shouldn't be the only metric to determine business health:
- Non-GAAP. EBITDA isn’t defined under Generally Accepted Accounting Principles (GAAP), and companies may calculate or adjust it differently. This may make comparisons less reliable unless you understand exactly how each figure was calculated.
- Ignores capital costs. Depreciation and amortization may be non-cash expenses now, but the assets behind them may have required significant investment to acquire and ongoing investment in future maintenance or upgrades.
- Can overstate available cash. EBITDA doesn’t account for certain cash uses, so a strong number there doesn’t always mean a business has equally strong cash flow.
Best-Practice Checklist
Here are a few ways to get the most out of EBITDA calculations.
- Reconcile to GAAP. Clearly connect your calculations to figures reported in GAAP financial statements.
- Pair with cash flow analysis. Review operating and free cash flow to understand how EBITDA translates into cash generation.
- Document all add-backs. Keep a clear record of adjustments you used to calculate adjusted EBITDA and why you excluded each expense.
- Use multiple ratios for a full picture. Consider EBITDA alongside other metrics like cash flow or net income.
- Track results over time. Use a consistent calculation methodology to identify meaningful changes in operating performance
- Consult a financial advisor. Consider working with a professional to help make sure calculations are accurate and to help in situations where compliance or future planning matters.
Frequently Asked Questions About EBITDA
What does EBITDA stand for?
EBITDA stands for “earnings before interest, taxes, depreciation, and amortization.”
How is EBITDA calculated?
You can calculate EBITDA by adding net income + interest + taxes + depreciation + amortization. You can also start with operating income and add depreciation and amortization.
Why do lenders care about EBITDA?
EBITDA may help lenders see a business's underlying operating health, separate from certain financial decisions. If calculated over time, it may also show whether a business remains efficient even as revenue increases or decreases.
Is EBITDA the same as cash flow?
No, EBITDA is not the same as cash flow. EBITDA measures core operating profitability, while cash flow track show money moves into and out of the business.
What is a good EBITDA margin?
Different industries and lenders that use EBITDA may have different acceptable margins based on unique circumstances. It might be helpful to discuss with your specific banking institution or lender to clarify.
What is the debt-to-EBITDA ratio?
A debt-to-EBITDA ratio helps assess a company's ability to pay off its debt using its core operational income.
Can strong EBITDA help me qualify for a small business loan?
A strong EBITDA is one of several factors that may help you qualify for a small business loan. It might be useful to check if your lender includes EBITDA calculations as part of their small business loan considerations.
Why might EBITDA be misleading?
EBITDA doesn’t consider certain nuances in business finances. For example, it may not show how depreciation or amortization affects cash in other ways, such as maintenance or upgrade costs. It can hide debt burden, and it excludes working capital. Its calculations aren’t standardized, so companies might choose strong numbers and exclude others to make EBITDA look better.
How can I improve EBITDA before seeking financing?
Improving core operating profitability and documenting legitimate add-backs may help improve your EBITDA number. For example, you might cut certain operating expenses, negotiate longer supplier repayment terms, or expand gross margins through price changes.
What should I ask my lender about EBITDA?
It’s important to know exactly how your lender calculates EBITDA. You might ask which specific add-backs are allowed in Adjusted EBITDA and what the maximum debt-to-EBITDA ratio is. You may also want to understand the specifics the lender requires for your industry.
