What exactly is it? EBITDA is a valuable indicator for evaluating a company’s operating performance and assessing its ability to create cash flow for its shareholders.
Let us begin from the beginning. Earnings before interest, taxes, depreciation and amortization (EBITDA) is the acronym for earnings before interest, taxes, depreciation, and amortization. EBITDA is a financial metric used to calculate a company’s earnings after subtracting taxes, depreciation, amortization, and interest costs giving you a clearer view of a business’s operations.
What is earnings before interest, taxes, depreciation, and amortization (EBITDA)?
Let us begin from the beginning. Earnings before interest, taxes, depreciation and amortization (EBITDA) is the acronym for earnings before interest, taxes, depreciation, and amortization. EBITDA is a financial metric used to calculate a company’s earnings after subtracting taxes, depreciation, amortization, and interest costs. Thus giving you a clearer view of a business’s operations.
This statistic also removes debt-related expenses by adding back interest expenditure and taxes to earnings. Nonetheless, because it can reflect earnings before accounting and financial deductions, it is a more precise indicator of business performance.
Explained, EBITDA is a profitability metric. While there is no legal requirement for corporations to publish their EBITDA, it can be calculated and reported using information from their financial statements, according to the US generally accepted accounting principles (GAAP).
The income statement includes figures for earnings, taxes, and interest, whereas depreciation and amortization are usually included in the notes to operating profit or on the cash flow statement. Starting with operating profit, also known as earnings before interest and tax (EBIT), and adding back depreciation and amortization is a standard shortcut for calculating EBITDA.
What does EBITDA stand for?
The meaning of EBITDA’s acronym is broken down to the following:
E – Earnings
B – Before
I – Interest
T – Taxes
D – Depreciation
A – Amortization
The components of EBITDA
To utilize EBITDA effectively, you must first grasp what each formula component entails.
- Earnings: Earnings are simply the amount of money your firm makes over a given period. Just remove your operational expense from your total revenue to get this component of EBITDA.
- Interest: An interest expense is, of course, the cost of repaying a debt. It can also refer to interest that has been earned, albeit it usually alludes to a cost. Interest costs are not deducted from earnings when calculating EBITDA.
- Except for EBITDA, which quantifies a company’s earnings before taxes, there are only two things certain in life: death and taxes. Earnings before interest and taxes, or EBIT, is a term used to describe earnings before interest and taxes.
- Depreciation and amortization: Depreciation is used to describe the decline in the value of tangible assets such as machinery or automobiles over time. The cost of amortization is associated with the eventual expiration of intangible assets such as patents. Depreciation and amortization are added back to operational profit in EBITDA.
What is LTM EBITDA?
The meaning of LTM (Last Twelve Months) EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a valuation indicator that illustrates your earnings before interest, taxes, depreciation, and amortization for the previous 12 months.
EBIT vs. EBITDA: What are the differences?
The number of steps taken is the main difference between EBITDA and EBIT. EBIT (Earnings Before Interest and Tax) is a metric that only shows earnings before interest and taxes. EBITDA goes a step further by identifying and reducing depreciation and amortization costs.
So it’s not a question of EBITDA vs. EBIT. Both help put up a picture of a company’s worth, as they break down business expenses and the proportionate impact on its value.
Other variations of EBITDA worth noting are as follows:
- EBIAT (Earnings Before Interest After Taxes)
- EBID (Earnings Before Interest and Depreciation)
- EBITDA (Earnings Before Interest, Depreciation, and Amortization)
- EBITDAX (Earnings Before Interest, Tax, Depreciation, Amortization, and Exploration)
- EBITDAR (Earnings Before Interest, Tax, Depreciation, Amortization and Restructuring/Rent Costs)
- EBITDARM (Earnings Before Interest, Tax, Depreciation, Amortization, Rent and Management Fees)
All computations may be extremely valuable in determining the worth of a business, which is why prospective buyers and investors frequently use them to compare companies. As a result, in addition to many other tools and approaches, our experienced M&A professionals use EBITDA as a significant part of our clients’ preparations for exiting their organization.
How to calculate EBITDA?
EBITDA is a straightforward calculation. Begin with a company’s annual SEC Form 10-K or quarterly SEC Form 10-Q report filed with the Securities and Exchange Commission in the United States. You’ll find line items for all of the things in EBITDA in the operating statement:
- Earnings (net income or net loss)
- Interest expense (sometimes also interest income)
- Income tax expense (sometimes also tax credit)
- Depreciation and amortization (typically combined but sometimes as separate line items)
Then sum up all the spending line items, remove any income line items (such as interest income), and add the total to the net income (or net loss) figure. The result is earnings before interest, taxes, depreciation, amortization, or EBITDA. In other words, you’re adding any expenses from these categories to the company’s net income (and deducting any gains from it).
Note: Many companies also report adjusted EBITDA. This is not the same as EBITDA since it includes additional expenses such as stock issuance, nonrecurring expenses, and other material items that affect the results. While adjusted EBITDA can be helpful, it can also be used by company management to support a narrative that frames the company in the best light while disregarding items investors should factor into their analysis and not ignore.
The limitations of EBITDA
EBITDA is a valuable measure for analyzing a company’s actual operating results, comparing it to similar organizations, and determining the influence of its capital structure on its bottom line and cash flows.
On the other hand, Misusing EBITDA can have a detrimental influence on your profits. EBITDA should not be regarded as the sole indicator of a company’s financial performance, nor should it be used as an excuse to ignore the impact of a company’s capital structure on its financial performance.
EBITDA should be viewed as only one of many tools in your financial analysis toolbox. The following example demonstrates why depending entirely on EBITDA can be a mistake.
Who uses EBITDA?
Retail investors can quickly learn EBITDA to help them value a potential investment before adding it to their portfolio. Finance professionals use EBITDA to understand how profitable a company is, but retail investors can use it to help them value a potential investment before adding it to their portfolio.
A company’s management team frequently uses EBITDA to provide insight into its value and illustrate its worth to potential investors.
Banks use EBITDA because it provides them with a picture of a company’s ability to repay debts. Financial analysts often use the formula to determine what drives a company’s worth and to anticipate future profits.
What is the EBITDA formula?
You may calculate your company’s EBITDA once you have numbers for each component listed above. The formula is as follows:
EBITDA = Revenue – Expenses (excluding tax, interest, depreciation and amortization)
To put it another way, EBITDA is net income plus interest, taxes, depreciation, and amortization. The following is an example supplied by Ron Auerbach, a lecturer at the City University of Seattle.
Let’s say company A has the following financial information:
- Net income – $1.8 million
- Interest paid – $260,000
- Depreciation – $180,300
- No amortization
- Taxes paid – $132,500
If you’re starting your EBITDA calculation with your net income instead of revenue, you will use this formula:
EBITDA = Net income + Taxes + Depreciation + Amortization + Interest
$1.8 million + 132,500 + 180,300 + 260,000
The EBITDA would be $2,372,800.
Because EBITDA is not one of the generally recognized accounting standards, not every company uses it. GAAP regulations apply when corporations release financial statements to shareholders or other external sources. EBITDA can be a valuable tool for courting investors or comparing one business to another for a company with long-term growth potential. When a corporation starts utilizing EBITDA without warning, it could be a sign that they’re trying to hide their finances in some way.
What is adjusted EBITDA?
The distinctions between EBITDA and adjusted EBITDA are minor, but they are crucial to understanding. Adjusted EBITDA, in essence, normalizes this metric depending on a company’s revenues and expenses. These can differ significantly amongst businesses, making it difficult for analysts and buyers to assess whether one is more enticing.
By standardizing income and cash flows and removing any anomalies (duplicate assets, owner bonuses, rent paid above market value, and so on), people can analyze multiple enterprises at once, regardless of variances in industry, geography, or other factors.
Using one of the basic EBITDA formulae above, calculate adjusted EBITDA, but go a step further by subtracting the cost of different one-time, irregular, and nonrecurring expenses that do not influence the day-to-day operations of your organization.
What’s excluded in adjusted EBITDA?
Here is a concise list of the standard balance sheet features excluded when applying adjusted EBITDA:
- Non-operating income
- Unrealized gains or losses
- Non-cash expenses
- One-time gains or losses
- Share-based compensation
- Litigation expenses
- Special donations
- Above-market owners’ compensation
- Goodwill impairments
- Asset write-downs
- Foreign exchange gains or losses
Arguments against EBITDA
While many people believe that EBITDA is a good predictor of performance, some believe that the calculations are deceptive and do not accurately reflect profitability. EBITDA, like any instrument, can be used for good or bad. Thus, the spectator must take their conclusions. On the other hand, EBITDA has been the subject of several long-standing critiques.
The most significant criticism of using EBITDA as a performance indicator is that it does not consider changes in working capital. Along with interest, taxes, and capital expenditures, this indicator of the company’s liquidity swings.
While a negative EBITDA figure usually indicates a company’s profitability problems, a positive value does not always imply a thriving company because taxes and interest are actual expenses that businesses must account for. In contrast, if a company’s assets are difficult to convert into cash but still maintain a high level of profitability, it may have poor liquidity.
EBITDA can sometimes give a skewed impression of how much cash a company has on hand to pay interest. When depreciation and amortization are factored in, a company’s earnings can appear to be higher than they are. Changes in depreciation schedules can also exaggerate a company’s profit expectations.
The reason for a company’s reliance on EBITDA is a crucial indicator of whether it is doing so in good faith. For a good cause, startups, especially those that require significant upfront investment to attain future development, are likely to employ EBITDA. It’s also helpful in comparing a company’s performance to competitors, industry trends, and macroeconomic trends. However, if a troubled company suddenly starts depending on EBITDA when it has never done so previously, the formula is most certainly misapplied.
What is a good EBITDA?
You may not want to consider if an EBITDA number is positive or negative. On the other hand, EBITDA might be useful as a metric for comparing companies. Compared to its peers, a company’s EBITDA may be impressive, but it may not be so remarkable compared to competitors in other industries.
To construct an EV/EBITDA multiple, EBITDA is frequently combined with enterprise value.
According to John O’Connor, vice president, and senior analyst at RMB Capital, this and other multiples, including price-to-earnings and price-to-sales, “may be utilized to assess valuation amongst companies in the prevailing market conditions.” “Multiples can be used to discover which companies are significantly less richly valued if all valuations are high.”
EBITDA is divided by revenue to calculate EBITDA margin, which investors utilize. A good EBITDA margin is higher than its rivals and higher than the industry average.
A high EBITDA margin indicates that a company’s cash flow is strong and that the business is likely to be profitable.
EBITDA vs. Net income
You might be thinking at this point, “Why not just utilize net income, which is simply revenue minus expenses?”
Net income is a measure of a company’s earnings that includes all of the metrics that EBITDA does not. Net income is a measure of a company’s profitability after all expenses have been deducted. Therefore, it may be thought of as a more thorough perspective of its profitability.
“Because many companies use non-cash expenses like depreciation and amortization to minimize their taxable income,” says Sam Brownell, founder of Stratus Wealth Advisors, “net income is frequently not the best gauge of a company’s cash flow potential.”
Operating income vs. EBITDA
Operating income is a company’s profit after operating expenses like depreciation and amortization have been deducted. EBITDA takes it a step further by removing them totally to provide a clear picture of its profitability.
Nonetheless, these are useful metrics to consider when assessing a corporation, as operating income is valuable for analyzing a company’s core operations and spending management.
How to increase EBITDA?
It would help if you strived to present statistics dating back 3-5 years when presenting your company’s EBITDA and other financials for the goal of departing the firm. This amount of data shows how your company has grown over time, telling purchasers that your growth potential is steady and that you haven’t had one exceptional year.
Because of the scope of these estimates, we highly advise our clients to collaborate with financial professionals and to offer reasonable, predictable, and dependable values. The more precise these are the lesser your company’s risk from potential purchasers and investors.
Of course, once you’ve calculated your company’s EBITDA, you’ll probably want to boost it before putting it on the market. Fortunately, recasting your money can help you achieve this.
Recasting your EBITDA value
The act of revising and re-releasing previously issued earnings statements with a specific objective is known as recasting. In practice, an expert will examine your accounts closely to reinsert any one-time revenues or expenses.
This reexamination gives potential buyers a more accurate and promising view of your company’s worth and future. Do not mistake this for lying — due diligence will reveal inconsistencies, so this is not an opportunity to hide the truth.
Numerous variables can be recast to enhance your company’s EBITDA and offer a more accurate image of its value. These are some of them:
- Revenue/expenses from non-essential assets — for example, if you hire a country property for a corporate retreat every year, this is a cost that a buyer may not recognize.
- Owner salaries/bonuses — Owner pay and bonuses will almost certainly be higher than those of other employees, but they will not be expenditures that a new owner must bear.
- One-time costs — whether you paid for a legal battle or a one-time marketing effort, these are not ongoing expenses that a buyer would have to bear.
- Non-arm’s-length revenue/expenses — transactions in which your firm pays more or less than market rates, such as rent when one of the partners owns the building personally. Normalizing these to reflect their actual market worth is possible and recommended.
- Repairs/maintenance — private business owners frequently classify capital expenses like repairs to reduce taxes, although this damages the company’s valuation in the long run by lowering historical EBITDA.
These are just a few of the critical areas where you might try to normalize EBITDA to make sure it’s maximized and accurately reflects your company’s value.
What is the debt to EBITDA ratio?
Divide a company’s liabilities by its EBITDA value to get the Debt to EBITDA ratio. It assesses a company’s ability to repay its debts promptly. The smaller the ratio, the more likely a company will meet its commitments on time. In contrast, a more significant figure indicates that clearing debts may be problematic, which serves as a warning flag to potential buyers.
What is the EBITDA to sales ratio?
Analysts and purchasers use the EBITDA to sales ratio to measure a company’s profitability by comparing revenue to earnings. This is computed by dividing EBITDA by the sales of a company. It’s beneficial for comparing similar-sized organizations whose cost structures’ underlying variables are unclear.
What is the EBITDA to fixed charges ratio?
The EBITDA to fixed charges ratio, like the Debt to EBITDA ratio, determines a company’s ability to pay down fixed charges and related debts over a four-quarter trailing period.
What is the difference between my EBITDA margin and my profit margin?
The net profit margin, computed using the formula below, is one of the most important indications of a company’s financial health.
Net Profit Margin = (Revenue – Cost of Goods Sold – Operating Expenses – Other Expenses – Interest – Taxes) / Revenue x 100
This shows how much profit is generated for each dollar of sales. EBITDA varies from this in that it accounts for all expenses incurred during production and daily operations while subtracting depreciation and amortization costs.
What is the difference between cash flow and EBITDA?
Free Cash Flow and EBITDA are two methods for determining a company’s worth and profitability. On the other hand, free cash flow shows a company’s earning potential once necessary expenses such as interest, tax, depreciation, and amortization have been removed. Instead, it adjusts its profitability by including depreciation and amortization before reducing working capital changes and expenditures.
Among the many methods for determining business value, both should be applied.
Is EBITDA a GAAP measure?
EBITDA is not a Generally Accepted Accounting Principle (GAAP)-based financial performance indicator. As there is no defined approach to EBITDA, its computation can differ from one company to the next.
The bottom line
Even though EBITDA can provide a valuable overview of a company’s profitability and make comparisons to other companies in the industry more effortless, it’s ideal for including additional metrics in your analysis for a more holistic picture of a company’s value.