EBITDA is one of those terms that even non-finance people have heard about.
However, not everybody really knows what EBITDA is, understands its benefits and limitations, and knows how to apply it when assessing a company’s profitability.
In this guide, we’ll be diving into exactly that.
We’ll provide a definition for EBITDA, explain how to calculate it, discuss its role in evaluating profitability and financial health, and discuss some of the big drawbacks associated with this financial metric.
Definition of EBITDA
EBITDA is an acronym that stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.
It’s a financial metric that is very commonly used to measure a company’s operational performance.
The reason for this is that by excluding interest, taxes, depreciation, and amortization—those expenses that are real, but not related to business operations—EBITDA can act as a better measurement of the profitability of a company's core business operations.
It is often used in valuations, especially during investments as well as mergers and acquisitions, as it highlights the company’s potential earnings power independent of external variables such as the depreciation of capital assets.
How to calculate EBITDA
To calculate EBITDA, most finance professionals start with net income and then work backward from there, adding back interest, taxes, depreciation, and amortization expenses for the period.
Thus, the EBITDA formula is:
Let’s illustrate with an example. Say your net income for the previous financial period was $50,000, but you also paid the following non-operational expenses:
- Interest Expense: $10,000
- Taxes: $8,000
- Depreciation: $12,000
- Amortization: $5,000
Applying the formula to calculate your EBITDA for the period:
$50,000 + $10,000 + $8,000 + $12,000 + $5,000 = $85,000
The importance of EBITDA in financial analysis
EBITDA is one of many key metrics used in financial analysis.
It offers insights into a company’s operational performance by looking at profitability before the impact of external factors such as:
- Financing decisions
- Tax environments
- Non-cash accounting practices
One of the main uses of EBITDA is to evaluate the core operational efficiency of a company. That is, it's used to answer the question:
How well is this company generating profit from its core operations?
From the perspective of the business, EBITDA is also a crucial metric when looking to attract investors or buyers. It provides a simplified view of the company’s earnings potential and gives investors a sense of the company’s worth based on how it performs operationally.
It also makes comparing companies that have different capital structures or that operate in different countries and are therefore subject to different tax requirements, easier.
Say, for instance, that you’re an investor weighing up two potential investment opportunities. You’ve got $10 million to invest and you’re considering two different startups, both of which have a net income of $2 million annually.
But by comparing EBITDA, you can strip away external factors like taxation and depreciation, and see that one company has a much higher depreciation expense because it invested very early on in a lot of capital assets like manufacturing machinery.
When comparing EBITDAs, that company is much more profitable, demonstrating that it is stronger in its core operations and making it a much more valuable investment opportunity.
Interpreting EBITDA results
So you’ve calculated your EBITDA. What can you do with that information?
Role in evaluating profitability
EBITDA tells you about the profitability of a company’s core operations. It's unburdened by variables like financing, tax rates, and asset management decisions that can distort net income.
Thus, you can use EBITDA more accurately to compare your business against others in different industries or jurisdictions that may have different financial structures or tax requirements.
Generally speaking, we can say that a positive EBITDA suggests that a company is generating sufficient income from its core operations, while a negative EBITDA might indicate operational inefficiencies or unsustainable cost structures, such as over-reliance on debt as a funding instrument.
More important, however, is to compare EBITDA figures over time, with an upward trend being desirable.
The link with cash flow
EBITDA is often considered a proxy for operating cash flow.
That’s because it excludes non-cash expenses like depreciation and amortization.
This said, EBITDA does not account for actual cash movements, such as changes in working capital or capital expenditures. For example, if you have to make an interest payment on a business, this would not be included in your EBITDA, but this is still a very real payment that requires a cash transaction.
Thus, while EBITDA does offer insight into operational performance, it should be viewed alongside a cash flow analysis to provide a complete picture.
Role in business valuation
EBITDA plays a huge role in business valuation. It is regularly used in mergers, acquisitions, and investment decisions.
That’s because it provides a standardized metric to assess a company’s earnings power, allowing for a more accurate comparison of investment options.
EBITDA is also commonly used in valuation multiples, such as the Enterprise Value/EBITDA ratio, to estimate a company’s worth in relation to its operational earnings.
Methods for incorporating EBITDA into valuation models
There are three primary ways in which investors and business leaders incorporate EBITDA into their valuation models:
- EBITDA multiples. Analysts often apply industry-specific multiples to a company’s EBITDA to estimate its enterprise value. For example, if a company has an EBITDA of $10 million and its industry multiple is 8x, an analyst might value that business at $80 million.
- Discounted cash flow (DCF) models. EBITDA can be used as a starting point for calculating free cash flow in DCF models. Adjustments for taxes, interest, and capital expenditures are made to figure out the net cash flow used in valuation.
- Comparable company analysis. EBITDA makes it easier to compare similar businesses to gauge relative valuation, which gives investors a quick and rough way to identify whether a company is undervalued or overvalued.
EBITDA limitations, disadvantages, and nuances
EBITDA may be a widely used metric, and it's true that it has its uses. But it's far from perfect, and there are some important limitations to be aware of if you plan on using EBITDA to assess your own company.
Here are the three main limitations of EBITDA as a financial metric.
1. It excludes key costs
The main benefit of EBITDA can also be its biggest drawback.
Interest, taxes, and capital expenditures are all real expenses. Removing them can overstate profitability and fail to accurately reflect the cash flow that is available to stakeholders.
2. It ignores capital expenditures
Businesses that have invested significantly in non-current assets might appear more profitable under EBITDA, even though large portions of their earnings are being reinvested in maintaining operations and paying down debts.
3. It’s not a GAAP metric
Since EBITDA is not governed by Generally Accepted Accounting Principles (GAAP), there is no specific requirement for how to calculate it.
That means that different companies can apply slightly different formulas, limiting your ability to make reasonable comparisons.
Common adjustments made to EBITDA
Adjustments are often made to EBITDA to normalize a company’s earnings and make them comparable across periods.
Here are some of the most common adjustments made when calculating EBITDA:
- Non-recurring expenses such as legal settlements or restructuring costs
- Owner or management compensation
- Unrealized gains or losses
- Startup costs such as R&D expenses
- Gains or losses on the sale of assets
- Other non-cash expenses like stock-based compensations
- Extraordinary events such as natural disaster cleanups
Maximizing EBITDA to enhance business worth
Whether you’re looking for funding or positioning your business for an upcoming merger, improving your EBITDA is a smart move.
One of the most effective ways to improve EBITDA in a truly meaningful way is to improve your expense management. If you can get business costs under control, you’ll naturally increase profits.
A financial operations platform like BILL can be the perfect partner here.
Our Spend & Expense solution, for example, is packed with features for cutting costs, such as:
- Real-time spend tracking
- Easy employee expense reimbursement
- Access to business credit
- Smart budgets with customizable spend controls
Discover how BILL can help you boost EBITDA today.
*The BILL Divvy Card is issued by Cross River Bank, Member FDIC, and is not a deposit product.
