What is EBITDA?
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Simply put, it shows you the profitability of your day-to-day operations.
By removing these factors, you can evaluate a company’s profitability and cash flow from their core operations.
The EBITDA formula
The EBITDA formula is:
EBITDA = Net Income + Interest Expense + Taxes Paid + Depreciation Expense + Amortization Expense
Net income: your bottom line—quite literally, since it’s at the bottom of the income statement. This is the amount your business pockets after all of its operating expenses, taxes paid, and interest expenses. You may also know it as net profit or net earnings.
Interest expense: the total amount of interest paid across all your debts. This includes loans, leases, lines of credits, and mortgages.
Taxes paid: the total amount paid in state and federal taxes. Adding your interest expenses and taxes paid to your net income gives you your operating income.
Depreciation expense: the practice of spreading a physical asset’s value out over its lifetime allowing you to deduct the expense over multiple tax years. Common physical assets that you can depreciate include vehicles, equipment, and property.
Amortization expense: the practice of spreading an intangible asset’s value out over its lifetime allowing you to deduct the expense over multiple tax years. Common intangible assets that you can amortize include patents and trademarks.
Further reading: What Is Depreciation? and How Do You Calculate It?
Why is EBITDA important?
Lenders, and investors will evaluate a business’s growth potential based on its EBITDA and working capital. If you recorded a negative net income for the year, your EBITDA can tell you a more hopeful story! You can calculate your EBITDA easily by looking at your financial statements.
Consider EBITDA as a measure of a company’s ability to be profitable in the absence of lending, investing, or taxation.
If your EBITDA value is positive, your core operations are profitable. It could be the interest on your loans or how you depreciated an asset that’s giving you a negative net income. But if your EBITDA value is negative as well, it’s time to look to cut your day-to-day costs of operations. Look to reduce your recurring expenses and cost of goods sold.
An example of EBITDA
Gemma’s Jewelry had a bit of a down year for sales in 2020, recording a negative net income of -$5,000 when she filed her taxes. Included as expenses on that tax return was $4,000 of taxes paid, $2,000 in interest expense, and a depreciation expense of $500 from a laptop she purchased two years ago.
While Gemma recorded a negative net income in 2020, were her core operations profitable? If you calculate her EBITDA:
Gemma’s EBITDA = Net Income + Interest Expense + Taxes Paid + Depreciation Expense + Amortization Expense
Gemma’s EBITDA = -$5,000 +$2,000 + $4,000 + $500 + $0
Gemma’s EBITDA = $1,500
Gemma may have recorded a negative net income, but when you take away the costs that weren’t connected to her operations (interest and taxes) and the expenses that were a carry over from a previous purchase (depreciation), she was profitable.
Use EBITDA to evaluate the profitability of your core operations. If you record a negative net income but a positive EBITDA, you can start exploring refinancing options to reduce your interest rates and as a result, your interest payments.
What is EBITDA margin?
There’s no good or bad EBITDA. Different businesses of different sizes and stages will have widely different EBITDA numbers. Instead, it’s best to understand your EBITDA margin.
An EBITDA margin is similar to profit margin. But instead of calculating your total revenue that resulted in net profit, it shows how much of your total revenue resulted in EBITDA.
The formula for EBITDA margin is:
EBITDA margin = EBITDA / Total Revenues
Your EBITDA margin will be a good indicator of how much of your sales actually ends up staying in the business before interest expenses and taxes.
An example of EBITDA margins
Let’s take a look at two different companies:
Company A had total revenues of $1 million with an EBITDA of $100,000
Company B had total revenues of $1.5 million with an EBITDA of $120,000
Company B had more revenues and a greater EBITDA than Company A. But this doesn’t mean Company B is better performing. Investors and lenders would look at the EBITDA margin of these two companies.
Company A’s EBITDA margin = 100,000/1,000,000 = 0.10
Company B’s EBITDA margin = 120,000/1,500,000 = 0.08
While Company B has a higher EBITDA and total revenue, Company A has a higher EBITDA margin. This shows that for each additional dollar of total revenue, Company A is keeping more of that money in the business. Lenders and investors see this as a strong indicator of potential growth.
The drawbacks of EBITDA
EBITDA does not fall under Generally Accepted Accounting Principles (GAAP) because of the way that the formula can be manipulated. A company’s EBITDA doesn’t accurately capture capital expenditures (things like new equipment or property) that show up on the balance sheet.
Capital expenditures of more than $2,500 and a lifetime of over a year will not impact a business’s EBITDA. This means a business can spend heavily on assets year over year and be losing money but still show a positive EBITDA.
When to calculate EBITDA
An EBITDA calculation is quick and easy with access to an income statement. But is it worth doing?
For new businesses taking on loans, you’re going to have higher interest expenses. These will impact your net income. But what will your profitability be in the future when the loans are paid off? Calculating your EBITDA can show you the profitability of your core operations for when you get there.
For businesses investing in capitalized assets, the amortization and depreciation expenses will be high. But since these costs are non-cash expenses, your EBITDA can show you the actual cash amount you earned through your business.
For businesses with no lending or investing in assets, there’s little to learn from your EBITDA. Simply put, if you don’t have interest expenses, depreciation expenses, or amortization expenses, EBITDA will not tell you much more about your business.
Adjusted EBITDA takes your calculation a step further by removing any one-time or non-recurring expenses that affect your bottom line. This will show you the profitability of your business without any of these one-time expenses, a better representation of your day-to-day operations.
Start by calculating your EBITDA and then add back in any expenses that were irregular for the period. Some examples of expenses to add back include:
- One-time legal costs
- Charitable donations and gifts
- Value-in-kind expenses
- Non-performance based payroll bonuses
- Non-cash expenses
Variations of EBITDA
EBITDA is just one acronym of many in the ways of calculating a company’s profitability. Some variations of EBITDA include:
- EBIT - Earnings Before Interest and Taxes (also known as operating profit)
- EBT - Earnings Before Taxes
- EBIDA - Earnings Before Interest, Depreciation, and Amortization
- EBIAT - Earnings Before Interest After Taxes
Each of these offer the same end result: a better understanding of profitability of your core operations. Each can be easily calculated by looking at your income statement. In choosing the measure that’s right for you, decide on what you want to control for. For example, if you want to understand how your interest payments affect your profitability, you would measure your EBT.
For more bookkeeping basics:
- Working Capital: What It Is and How to Calculate It
- FIFO: The First In First Out Inventory Method
- Liquidity: A Simple Guide for Businesses
- How to Read (and Analyze) Financial Statements
Know your operations in and out: