What Is EBITDA, and How to Calculate It?
When it comes to measuring a company’s financial performance, the EBITDA metric is often used as an alternative to other profitability metrics such as net income, cash flow, and capital expenditures.
What is EBITDA, though? And why exactly is it used?
Here’s everything you need to know about this metric, including why it’s important and how it’s calculated.
- EBITDA is an abbreviation that stands for earnings before interest, taxes, depreciation, and amortization.
- This profitability metric doesn’t account for non-operating decisions, including tax and interest rates. It’s primarily concerned with the financial outcome of operating decisions, so it’s neutral to capital structure.
- The EBITDA metric is important because it eliminates the effects of financing and accounting decisions when comparing a company’s profitability.
- While the EBIDTA metric can provide valuable insights regarding a company’s value, it has some limitations, such as not being able to measure financial health accurately or taking into account reinvestment in fixed assets, among other things.
- What Is EBITDA?
- The Importance of EBITDA
- What You’ll Need to Calculate EBITDA
- EBITDA Calculation
- The Limitations of Using EBITDA
- Frequently Asked Questions
- Use Multiple Metrics to Evaluate a Company
What Is EBITDA?
EBITDA is an abbreviation that stands for earnings before interest, taxes, depreciation, and amortization.
This profitability metric doesn’t account for non-operating decisions, including tax and interest rates. It’s primarily concerned with the financial outcome of operating decisions, so it’s neutral to capital structure.
The EBITDA metric, which is considered a variant of the EBIT metric (earnings before interest and taxes), is commonly used to assess a company’s performance without taking into account the impact of capital structure.
Though EBITDA is used extensively, it’s not recognized by the generally accepted accounting principles (GAAP) issued by the Financial Accounting Standards Board (FASB) or International Financial Reporting Standards (IFRS).
We can assume that it’s not recognized by said standards because it doesn’t account for expenditures and asset depreciation (i.e., loss of value with respect to time).
The Importance of EBITDA
The EBITDA metric is important because it eliminates the effects of financing and accounting decisions, as well as governmental decisions when comparing a company’s profitability.
Calculating EBITDA gives you a better idea of your company’s value. It also helps represent your company’s worth to potential investors and buyers. It can also help you decide if a company is worth investing in and what price it’s worth.
As a matter of fact, EBITDA is used by most private equity investors and professional buyers when trying to analyze and determine the value of a company. EBITDA is also used as a proxy for cash flow.
What You’ll Need to Calculate EBITDA
Calculating EBITDA is quite straightforward, provided you’re keeping accurate financial records. This places a great deal of emphasis on having a precise and up-to-date accounting system.
Now, if you take a look at the operating income statement in your annual SEC Form 10-K or your quarterly SEC Form 10-Q, you’ll find all of the components you need to calculate EBITDA.
To calculate EBITDA, you’ll need to find the following expenses, as per the equation above:
- Net income or earnings
- Interest expense
- Income tax expense
- Depreciation expense
- Amortization expense
Having gathered the above-listed values, you simply add them all, and the result you get is the earnings before interest, taxes, depreciation, and amortization (EBITDA).
There are quite a few ways to calculate EBITDA (earnings before interest, taxes, depreciation, and amortization), but the basic formula is:
- EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
Seeing as net income, interest, and taxes are often collectively cited as operating profit, and seeing as depreciation and amortization expenses are considered non-cash expenses, another way to look at EBITDA’s formula would be:
- EBITDA = Operating Profit + Depreciation + Amortization
To fully grasp the value of EBITDA, we have to break down the five components that are used to calculate the metric:
Net income, also referred to as net earnings, is an indicator of revenue that accounts for (as in subtracts) expenses such as operating costs, interest, taxes, and depreciation.
Investors use the net income metric to assess the extent to which a company’s profitability or revenue exceeds its expenses. It’s also used to calculate earnings per share.
It’s worth noting that net income is also used to represent an individual’s income or earnings after taxes and other deductions are taken into account.
Interest expense is one of the primary expenses in a cash flow statement. It’s usually the result of borrowed funds that are intended to finance a company’s assets.
Another transaction in which interest expenses are generated, apart from borrowing funds, is the use of capital leases. This is when interest expense is generated from leasing an asset from another company.
Interest expenses differ based on capital structure, which is why the relative performance of companies is often measured by accounting for interest rather than accounting for the impact of capital structure.
Seeing as tax expense isn’t a vital component when it comes to assessing performance, most analysts add it back when comparing companies in the same industry.
Tax expenses vary based on region. In other words, the taxes that a company is subjected to in one state will differ from those that another company is subjected to in another state.
As we alluded to earlier, depreciation is an expense that refers to the reduction of the value of a company’s assets over a period of time. It applies to tangible, fixed assets, such as buildings, equipment, vehicles, and so forth.
For example, if a company’s vehicles wear out over time, that should be calculated under the depreciation of company assets.
Note that depreciation is a non-cash expense, as it mainly depends on the company’s historical investment and not the company’s performance.
While depreciation is based on fixed, tangible assets, amortization is based on intangible assets. Examples of intangible assets include licenses, computer software, trademarks, import quotas, and the like.
Similar to depreciation, amortization depends on the historical investments that a business or company has made. It doesn’t have anything to do with the current operating performance. It’s also a non-cash expense, just like depreciation.
It’s worth pointing out that some companies and businesses report adjusted EBITDA, which is slightly different from standard EBITDA, as it eliminates irregular and non-recurring expenses.
By eliminating abnormalities, it becomes easier for financial analysts to compare multiple companies at once, regardless of region, industry, and other influential factors.
Some of the expenses that are excluded in adjusted EBITDA include:
- Unrealized gains and losses
- One-time gains and losses
- Special donations
- Goodwill impairments
- Litigation expenses
- Asset write-downs
The Limitations of Using EBITDA
While the EBITDA metric can provide valuable insights regarding a company’s value and its worth to investors and buyers, this profitability metric has some limitations.
Here are some of the most notable limitations of EBITDA:
EBITDA Isn’t an Accurate Measure of Financial Health
For starters, EBITDA isn’t to be used exclusively as a measure of financial health. After all, this metric is neutral to the effects of capital structure on financial performance.
Basically, the EBITDA metric is one of the many metrics you should be using in your financial analysis, as opposed to being the only metric used.
To help you understand why EBITDA shouldn’t be the only metric you’re using, we have to highlight the influence of capital structure when comparing businesses to one another.
Let’s say you have two businesses within the same industry that have the exact same investments, tax rates, operating expenses, and revenue. The main difference between the two businesses is their capital structure.
Business X finances its assets through equity, whereas business Y finances its assets through debt. On the basis of EBITDA, both businesses might be equal, but in reality, the business running on debt financing will most likely be less profitable than the one running on equity.
To summarize this point, we can say that EBITDA is a great metric for comparing businesses at a surface level. However, it’s not an accurate measure of a company’s financial health because it won’t provide you with deeper insights into capital structure, tax differences, and other vital financial factors.
EBITDA Isn’t a Generally Accepted Accounting Principle (GAAP)
As we stated earlier, the EBITDA metric doesn’t fall under the GAAP principles. This is because it ignores expenditure, and companies can use this to subvert financial problems in their statements.
And since GAAP doesn’t recognize the EBITDA metric, companies can interpret its formula differently, leaving room for them to hide red flags that can deter potential investors and buyers.
It’s worth noting that there are some successful business people, like Warren Buffet, who are generally skeptical of EBITDA. This is because EBITDA excludes depreciation and capital expenditures.
EBITDA Does Not Account for Reinvestment in Fixed Assets
As we’ve learned so far, depreciation and amortization expenses are added back when calculating EBITDA. This means that EBITDA doesn’t take into account the need to reinvest in fixed assets on a regular basis.
This, once again, proves that EBITDA isn’t an accurate measure of financial health. The very fact that it doesn’t account for depreciation and amortization can make different companies in different industries look as if their operating profitability and operating expenses are equal.
To give you an example, let’s assume you’re comparing a company that’s in the manufacturing industry with a company that’s a bit more people-centric.
A company in the manufacturing industry is bound to need higher reinvestment expenses in its fixed assets than a more people-centric company.
In this case, using EBITDA to compare both companies wouldn’t be a good idea because it’s not going to shed light on the capital reinvestment needs of both companies, making both seem equal.
Frequently Asked Questions
What Is the Difference Between EBITDA and Cash Flow?
Both EBITDA and free cash flow (FCF) are used to assess profitability. The main difference is that free cash flow can offer you insights regarding earnings after meeting taxes, interest, and other financial obligations, whereas EBITDA can’t.
What Is the EBITDA to Sales Ratio?
This is a ratio that’s used to determine profitability by comparing revenue to earnings. It’s calculated by simply dividing the EBITDA value by the number of sales. This ratio is often used to compare similar businesses with cost structure variables.
What Is the Debt to EBITDA Ratio?
The debt-to-EBITDA ratio is one that represents a company’s ability to pay off its debts. It’s calculated by dividing liabilities by the value of EBITDA. The lower the result, the higher the possibility of paying off debt payments.
Use Multiple Metrics to Evaluate a Company
In summary, EBITDA is a profitability metric that helps evaluate a company’s operating performance without accounting for capital structure.
It’s used in place of cash flow but is a bit controversial, as it may not give a fully accurate picture of financial health.
Regardless, EBITDA is an important metric because it gives you an idea of a company’s value, which is helpful before investing.
That being said, it shouldn’t be the only factor on which your financial analysis is based. Instead, it’s one of the many metrics you should be using.