Get expert advice on every topic you need as a small business owner, from the ideation stage to your eventual exit. Our articles, quick tips, infographics and how-to guides can offer entrepreneurs the most up-to-date information they need to flourish.
EBITDA — shorthand for earnings before interest, taxes, depreciation, and amortization — is a helpful metric for analyzing your company’s profitability. Because it strips out all nonoperational expenses, EBITDA allows you to see how much profit your company is making from its core business activities.
While some assume that EBITDA and cash flow are synonymous (and use the terms interchangeably), this is incorrect. These two aren’t the same and provide different views on a business’s financial position.
Calculating EBITDA is relatively simple. You just need to take your business’s net income and add back interest, taxes, depreciation and amortization.
What are the applications of EBITDA?
The main benefit of using EBITDA is that it provides a good view of your company’s health and how well its business model is working. It only accounts for necessary expenses for the business’s daily operations, and it represents the cash flow generated by ongoing operations.
Since it excludes factors like debt, taxes, depreciation and amortization, EBITDA can be helpful in comparing businesses across different industries, since different companies can have vastly different levels of overhead or taxes.
EBITDA can also be used to assess a company’s value, since it provides an indication of how well managed the company is. And in the financial industry, borrowing limits for businesses may be set as a percentage of EBITDA.
Additionally, using multiples of EBITDA is a method sometimes used to value small businesses that are being acquired. For instance, if you own a company that generated $1 million of EBITDA in the previous year, and firms in your sector normally sell for five times EBITDA, your business’s sale price will probably be in the range of $5 million.
How do you calculate EBITDA?
EBITDA is calculated by taking a company’s net income, and then adding back all interest, taxes, depreciation and amortization (EBITDA) expenses.
The formula is: EBITDA = Net income + Interest + Taxes + Depreciation & Amortization.
The result provides insight into a company’s profitability without all the nonoperational elements.
To find your own business’s EBITDA, you’ll need to gather some key financial statements. Check the income statement for the time period you want to analyze. In addition, you may need a cash flow statement for the same period to identify depreciation and amortization.
Example: ABC Bookshop reviews its quarterly income statement and cash flow statement and notes the following figures:
There are a few disadvantages to using EBITDA. First, it’s possible to manipulate EBITDA by changing the way you depreciate assets.
Second, EBITA fails to account for a variety of costs. Third, because it factors out interest, taxes, depreciation and amortization, it can create a misleading impression of a company’s financial health.
While EBITDA is a valuable measure for measuring a company’s earnings, it’s a non-GAAP-number. It’s also not without controversy due to its vulnerability to manipulation.
After all,Worldcom’s implosion in 2002 – the largest corporate accounting fraud case in U.S. history at the time – was attributed to the company’s misclassification of certain expenses to inflate its EBITDA.
As such, it is important to treat EBITDA with caution and not put too much faith into any one figure. EBITDA should always be assessed together with otherkey performance indicators such as net income.
EBITDA versus other financial ratios
EBITDA should be just one tool in your arsenal, as there are other financial ratios that can give you a more comprehensive picture of your business’s financial health. Gross profit margin ratio and net profit margin ratio are two such important ratios.
While gross profit margin ratio measures how much gross profit is earned from each dollar of revenue, net profit margin ratio shows how much net income is earned from each dollar of revenue. Both these ratios are important indicators of the overall profitability and performance of a company.
How can you use EBITDA to improve your business?
EBITDA can help you improve your business in a couple different ways. By looking at your EBITDA you can get a better idea of how profitable your company is from its core operations.
This can help you identify areas of your business that can be improved, such as streamlining processes, cutting costs or expanding into new markets. Additionally, you can use EBITDA to compare yourself against other companies in the same industry and use those numbers to come up with goals and strategies.
Overall, EBITDA is a helpful metric for analyzing your business’s profitability. By removing nonoperational expenses, you get a better picture of a company’s financial health.
Calculating EBITDA is fairly easy, and there are many benefits to using this metric, such as comparing companies across different industries and assessing a company’s value. However, there are also some drawbacks to EBITDA, such as the fact that it can be manipulated.
At the end of the day, EBITDA is a useful tool, but business owners shouldn’t base their plans on a single number. Rather than using only a single metric, make your financial moves based on the most complete picture you have.
Want more? Escalon has helped over 5,000 companies across a range of industries to optimize routine business functions, like HR and payroll, and operate more efficiently. Talk to an expert today.
Celene heads up the marketing at Escalon. Passionate about helping companies grow their business, she spends her days finding new ways to bring essential business services to startups, SMBs, and growth-minded companies. Based in the PNW, she’s the proud owner of 8 pairs of Birkenstocks and a sassy, cuddly cat.