EBITDA is short for earnings before interest, taxes, depreciation and amortization. It is one of the most widely used measures of a company’s financial health and ability to generate cash.
“EBITDA is a key indicator of a business’s performance, profitability, value and ability to add debt,” says Fanny Cao, a CPA, CGA and Senior Advisor, Financial Products at BDC.
“It’s a clean picture of the core profit of a company and a good shortcut to give a quick picture of its available cash flow.”
What is EBITDA?
EBITDA is a measure of a business’s core profitability after stripping out factors that aren’t in the company’s control or that may distort earnings, such as:
- Interest, which can vary depending on the company’s credit history, financing structure and location
- Taxes, which can depend on jurisdiction
- Depreciation and amortization, amortization refers to tangible assets such as buildings and equipment, as well as intangible assets such as software and patents. All of these assets are amortized over their useful life. Depreciation reduces the value of the assets due to factors external to the business, such as inflation and economic conditions.
“EBITDA allows you to compare two companies in different locations, decide how much a business is worth and benchmark it against industry averages,” Cao says.
How do you calculate EBITDA?
EBITDA is calculated with the following formula using elements found in the income statement.
Net profit + interest + taxes + depreciation and amortization
Note that only interest on short- and long-term debt should be added in the formula. Other types of interest should not be included, such as interest on accounts receivable. It’s important to have a breakdown of the interest line in the income statement to ensure the correct figure is added.
Also, only income tax should be added in the formula, not other types of tax such as property, payroll and sales taxes.
Example of an EBITDA calculation
In the example below, XYZ Co.’s EBITDA is:
|Depreciation and amortization||$145,000|
What does EBITDA tell us and how is it used?
EBITDA is widely used by businesses, valuators, bankers and others to compare a company’s financial performance to industry peers and gauge its profitability before non-core expenses and charges.
1. Businesses and valuators
Entrepreneurs and business valuators often use EBITDA to calculate a company’s valuation for purposes of a business sale or acquisition. A common valuation method is to apply a multiple to EBITDA to determine how much the business is worth. The specific multiple can vary depending on many factors, such as market conditions, industry and location.
2. Financial institutions
Bankers use EBITDA to get an idea of how much cash flow a company has available to pay for long-term debt. Bankers also use it to calculate a company’s debt coverage ratio, which is another measure of its ability to make debt payments.
“EBITDA is widely used in the financial industry,” Cao says. “It makes it easy to compare the core profit and potential of two companies in the same industry.”
Financial institutions also often use EBITDA as part of loan conditions known as debt covenants. For example, a business may be required to maintain a certain debt coverage ratio as a loan condition.
What is the difference between EBITDA, EBT and EBIT?
Earnings before taxes (EBT) measures a company’s profitability before income taxes are deducted. It’s the amount of operating income left after interest on debt, depreciation and non-operating income and expenses are factored in.
EBT is often seen as a truer reflection of profitability than net income because companies pay tax at varying rates in different jurisdictions. In the sample income statement above, EBT is $953,501.
Earnings before interest and taxes (EBIT) goes a step beyond EBT to also remove the impact of interest. The idea is to account for the fact that companies don’t carry the same debt loads and pay different interest rates depending on location and other factors.
In the income statement above, EBIT is calculated this way:
Why is EBITDA so important?
EBITDA is important because it is one of the metrics most commonly used by businesses, valuators, bankers, investors and others to gauge a company’s profitability, performance and valuation.
How is EBITDA used in acquisitions and buyouts?
During a business acquisition, the buyer often hires a professional business valuator to produce an independent valuation of the target company. The valuator is typically given access to financial documents and other information to establish a fair market value for the business.
A common valuation method is to apply a valuation multiple, which may be based on EBITDA, revenue or other metrics. After due diligence, the parties may revise the offer price based on an adjusted EBITDA or different multiplier depending on what was discovered.
Is EBITDA the same as gross profit?
In the income statement above, gross profit is $2,227,500.
Is EBITDA the same as operating profit?
No, operating profit (also called operating income) is what is left over after operating expenses (also called selling, general and administrative expenses, or SG&A) are subtracted from gross profit. In the example above, operating profit is $1,212,401.
Is EBITDA the same as the bottom line?
No, the bottom line (also known as net income, net profit or earnings after tax) is the money left after all expenses and taxes are deducted from all revenues and gains. In the example income statement, it is $922,251.
Does EBITDA include salaries?
Yes, EBITDA includes salaries. These may be found in both cost of goods sold/cost of sales and among operating expenses.
What is adjusted EBITDA?
Bankers, valuators and others sometimes modify the EBITDA formula to arrive at an adjusted EBITDA (also known as normalized EBITDA). A variety of adjusted EBITDA formulas exist depending on the use.
The main objective is to adjust for one-time and extraordinary items not connected to the core operating profit of the business, such as:
- nonrecurring income or expenses
- non-cash losses
- legal fees and settlements
- insurance claims
- non-market rent
- extraordinary items
What are the limitations of EBITDA?
EBITDA can sometimes paint a misleading picture of a company’s profitability. For example, a business that invests heavily in capital assets or intellectual property may have a positive EBITDA without being profitable.
“Because EBITDA adds back interest, amortization and depreciation, a company may have no net profit but high EBITDA,” Cao says. “It’s important to look at EBITDA alongside other indicators to get a true idea of a company’s financial health.”