Understanding EBITDA: What is it and how it is calculated?

EBITDA stands for earnings before interest, taxes, depreciation, and amortization and is one of the most popular metrics for evaluating a company’s cash flow and overall financial health.

This metric can reveal the state of a business and determine profitability to prospective investors and startup founders by using a step-by-step calculation.

What is EBITDA?

Considered to be a variation of operating income (EBIT) after stripping out some non-cash expenses, EBITDA represents a company’s core profitability.

It provides insight into the company’s capacity to make money from its core business activities instead of just net income. However, investors use it to assess and compare profitability across different business sectors and industries, irrespective of size, structure, taxes or assets.

Neither U.S. GAAP nor IFRS considers EBITDA as a relevant metric. Since it does not take asset depreciation into consideration, some investors do not favor using it. For instance, if a business has a substantial amount of depreciable equipment, the maintenance and sustenance cost of these capital assets is not recorded.

Before calculating EBITDA, you need to understand each component of the formula as listed below.

Earnings

The income or profit generated by a business.

Before

This suggests that you leave out specific items from your operational performance, which are all included in the remaining four parts of the EBITDA acronym.

Interest

Since interest expenses vary depending on a company’s financing structure, they are not included in EBITDA. Interest costs are incurred by a corporation from the money it borrows to run its operations.

Various businesses have various capital structures, which lead to various interest expenses. Thus, it is simpler to assess the relative performance of businesses when interest is added back and the impact of capital structure on business operations is disregarded. As interest payments are tax-deductible, companies can benefit from this, which is referred to as a corporate tax shield.

Taxes

Taxes are different and specific to the area in which the business operates. Since they are a result of a jurisdiction’s tax laws and aren’t relevant to evaluating the effectiveness of a management team, most financial analysts prefer including them back while comparing businesses.

Depreciation and Amortization

Depreciation and Amortization (D&A) is based on past investments made by the business, and not on how well the business is currently operating.

Businesses make investments in long-term fixed assets (like automobiles or buildings) that depreciate over time.  If the asset is intangible, amortization costs are incurred. For instance, patents are amortized as they have a limited period of use.

D&A is significantly impacted by assumptions about salvage value, useful economic life, and the depreciation technique used. As a result, analysts may find that operating income differs from what they think the number should be, and therefore D&A is excluded from the EBITDA calculation.

How to calculate EBITDA?

To calculate EBITDA, two distinct formulas are utilized. Each formula might yield various outcomes. But if you apply the same formula every year, you ought to be able to determine the value of your business and track its progress.

Formula 1: EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization

This EBITDA formula uses net income which is the amount of income a business has left over after all costs have been paid.

Formula 2: EBITDA = Operating Profit + Depreciation + Amortization

This EBITDA formula variant displays a company’s profit following the subtraction of its daily operating expenses. Moreover, taxes and interest are not included. This approach is usually adopted by more service-oriented companies since they own few fixed or intangible assets, if any.

For clarity, let’s consider a company ABC which accounts for its D&A expense of $12,000 as a part of its operating expenses. Its income statement notes the following figures:

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Using the formula, EBITDA = Net Income + Interest Expense + Tax Expense + Depreciation & Amortization Expense

ABC’s EBITDA = $19,000 + + $2,000 + $19,000 + $12,000 = $52,000

Why use EBITDA?

Investors and creditors use EBITDA to compare a company’s actual profitability, excluding losses unrelated to costs or revenue from production. This metric also reveals how robust an organization’s operational budget is in isolation from its assets, which might not be related to the business’s main offering. Businesses with costly assets and high debt levels might view their base profitability with EBITDA.

A company’s annual profitability might be largely skewed by its business assets. For instance, a company may decide to buy new office space instead of extending its lease on the existing one.  This new building’s amortization spreads the expense over several years as opposed to a single, hefty payment. EBITDA determines profitability without deducting the asset’s cost.

The bottom line

When comparing businesses with different tax treatment and capital costs, or when examining them in scenarios where they are anticipated to alter, EBITDA is a helpful metric. Though EBITDA is widely used by private equity firms due to its ability to compare companies that are similar within the same industry, it comes with its own set of disadvantages like forming a misleading impression of a business’s financial state.

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