EBITDA has become a standard means of measuring a company’s profitability, and for the uninitiated, it can be confusing as heck. It doesn’t need to be…. OK, it’s always going to be a little complicated but we’ll do our best to break it down.
We’ll walk you through everything you need to know about EBITDA, including what it means, how to calculate it (with simple formulas), why it’s used to measure companies’ financial performance and the limitations of using a company’s EBITDA to measure its value. Let’s get started.
What Is EBITDA?
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. You calculate EBITDA by taking a business’s operating income or net profit and adding back funds paid on taxes, interest expenses, depreciation, and amortization.
A simpler way to look at it is that its total revenue minus operating expenses.
EBITDA shows what a company can do, even if it’s not doing it right now. EBITDA was invented in the 1980s to calculate the value for leveraged buyouts. In those cases, companies were buying companies that were often not profitable. EBITA gave them a way to measure how profitable a company could be if it was restructured.
Today, EBITDA is widely used to calculate growth potential, commonly used in the startup, tech, and other venture capital (VC) funded industries.
We’re going to be talking a lot about earnings, interest, taxes, depreciation, and amortization. Let’s take a moment to cover what we mean when we use those terms.
- Earnings: Earnings refer to your net sales or gross margin, but there is some variation in how the initial “earnings” amount is determined. The 2 primary ways to calculate EBITA begin with either a company’s operating income or net income
- Interest: Interest expenses related to a business’s debt.
- Taxes: For US-based companies, these taxes typically include state and federal income tax. It typically does not include payroll tax, use tax, city tax, local tax, or real estate/property taxes)
- Depreciation: The reduction in the value of a tangible asset over time
- Amortization: Debt that is reduced or paid off with regular payments
When Does EBITDA Matter and Who Is It For?
A company’s EBITDA matters when it’s seeking investment from venture capitalists or traditional investors who are primarily interested in a business’s growth potential. EBITDA has become the predominant way to measure a company’s operating profit.
Given that EBITDA is one of the most complicated ways to calculate a company’s profit, you might be asking yourself, “Do I really need to know this?” The answer might be no. EBITDA generally only applies to these folks:
- Startups seeking investors and venture capital
- Business owners interested in selling their business to a venture capital firm
- Employees of a startup or VC-funded businesses
- People who followed the WeWork saga and still don’t understand what Adam Newman was talking about (kidding, but… true)
Breaking Down EBITDA Formulas
There are 2 methods of EBITDA calculation. The first is to start with a business’s operating income. The second is to start with net income. Your EBITDA margin may vary depending on which EBITDA formula you use.
How to Calculate EBITDA Using Operating Income
When you start your EBITDA calculation with operating income, you won’t have to add your depreciation, amortization, and interest payments in the final step because they have not been subtracted from your initial operating expense figure.
To use the “operating income” method of calculating EBITDA, follow these steps:
1. Calculate operating expenses.
Operating Expenses = Wages + Salaries + Sales Commissions + Marketing and Advertising Expenses + Lease Payments + Utilities + Cost of Goods Sold (COGS)
2. Calculate operating income.
Operating Income = Sales – Operating Expenses
3. Add depreciation and amortization to calculate EBITDA.
EBITDA = Depreciation + Amortization to your Operating Income
How to Calculate EBITDA Using Net Income
To use the “net income” method of calculating EBITDA, follow these steps:
1. Calculate net income.
Net Income = Gross Income – Expenses
2. Calculate EBITDA.
EBITDA = Net Income + Taxes + Interest Expense + Depreciation + Amortization
Other EBITDA-Related Calculations to Know
Once you know what a company’s EBITDA is, you can use that information to calculate related metrics to further analyze a business’s financial performance.
How to Calculate EBITDA Margin
EBITDA margin calculates a company’s profitability (calculated via EBITDA) as a percentage of revenue. To calculate EBITDA margin, use this simple formula:
EBITDA Margin = EBITDA / Revenue
How to Calculate Adjusted EBITDA
Adjusted EBITDA adjusts for anomalies, making it easier to compare with the EBITDA of other companies and a business’s broader industry. Anomalies might include costs like an excessive owner’s compensation (in which case the deviation from the industry average might be added into the adjusted EBITDA) or in the case of an understaffed company, salary costs that competitors have (in which case you would subtract those costs from the adjusted EBITDA).
Adjusted EBITDA = EBITDA +/- Adjustments
How to Calculate EBIT
A company’s EBIT is used to analyze the performance of the business’s core operational profits without the costs associated with the capital structure—the distribution of debt and equity of a company’s finances—and tax expenses.
EBIT = Net Income + Interest + Taxes
How to Calculate EBITDA-to-Interest Coverage Ratio
The EBITDA-to-interest coverage ratio, or also known as the EBITDA coverage ratio, is a ratio used to assess a company’s financial stability by measuring whether or not the company is profitable enough to pay off its interest expenses using its pre-tax income.
EBITDA-to-Interest Coverage Ratio = EBITDA / Total Interest Payments
How to Calculate EBITDA Multiple
The EBITDA multiple is a ratio that measures a company’s return on investment (ROI). To calculate an EBITDA multiple, you must first calculate enterprise value.
Enterprise Value = (Market Capitalization + Value of Debt + Minority Interest + Preferred Shares) – (Cash and Cash Equivalents)
EBITDA Multiple = Enterprise Value / EBITDA
The Pros of Using EBITDA
Proponents of EBITDA argue that the calculation gives a more accurate picture of a company’s profitability and operating cash flow. EBITDA illustrates how much a company is making in relation to what it’s spending, relative to business expenditures. It ignores heavy debt or tax burdens that might skew how profitable a business looks in the short term.
Theoretically, EBITDA also allows you to more accurately compare the profitability of different companies. Interest expense, amortization expense, and depreciation expense all affect a company’s bottom line on a traditional profit and loss (P&L) sheet, but they don’t indicate how profitable a company is based solely on its day-to-day operational expenses.
A company that’s scaling rapidly, for example, might take on substantial debt. With other accounting and valuation measures, that net debt might cause the company to operate at a loss. It doesn’t, however, give an investor a good sense of whether or not the company is investable or would be profitable once they have scaled and the debt has been repaid. EBITDA can also give you a better sense of a business’s working capital, or cash flow, than other metrics.
The Cons of Using EBITDA
EBITA has limitations. It doesn’t account for intangible assets or the non-cash value of a company. For this reason, EBITDA is less appealing to strategic investors. Strategic investors tend to have more of a knowledge base of the industry and so might be better able to spot an intangible asset that a company possesses. They might also see shared values that a company has with others in their portfolio. In those cases, the value of the investment might not be 1:1 against the company’s income statement or cash flow statement.
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