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EBITDA is an acronym standing for “Earnings Before Interest, Tax, Depreciation, Amortization”. It is a powerful indicator in terms of the profitability of a given business. It can be used instead of net income in certain instances, or as a complement to it.
However, like all metrics, it needs to be understood in depth so it can be utilized properly. It can be extremely misleading if it is taken out of context, which it often is. There are certain elements excluded in the formula which can paint a completely different picture once factored in.
With all of this in mind, we’ve broken down EBITDA for you so you can use it more intelligently and apply it in the right circumstances. We will also delve into the EBITDA margin ratio, the EBITDA coverage ratio, and the EBITDA multiple, all of which are critical in terms of understanding how EBITDA is used.
As previously stated, EBITDA stands for “Earnings Before Interest, Tax, Depreciation, Amortization”. Aside from the core formula, it is used in a wide variety of other formulas and provides a basic metric for further analysis. But to break down the individual components of the basic formula further:
- Earnings – The most straightforward metric. This is simply the amount of money you have made in a given time period, typically a year. In this instance, it is earnings before interest, tax, depreciation, and amortization, which are usually factored in.
- Interest – Interest paid to banks and financial institutions for loans and credit provided.
- Tax – Taxes the business pays to city, state, and federal authorities.
- Depreciation – Depreciating value of existing assets, which leads to a loss in net company value. This is a non-cash expense.
- Amortization – Similar to interest payments except that the rate of interest decreases with each payment. This is a non-cash expense.
EBITDA is basically what you earn before the 4 other variables are accounted for – interest, tax, depreciation, and amortization. It is especially relevant in terms of comparing two companies. For instance, one company might have better profit margins than another, but only due to the way it manages interest, tax, depreciation, and amortization. Some companies are way better at managing these than others.
You can also call EBITDA a measure of profitability before the other factors come into play. It is simple and quick to calculate the EBITDA formula.
EBITDA Formula & EBITDA Calculation
The EBITDA formula is actually quite straightforward. There are two primary EBITDA formulas and both of them are quite similar. They are:
|Net Profit + Interest +Taxes + Depreciation + Amortization = EBITDAEBITDA Formula & EBITDA Calculation|
|Operating Income + Depreciation + Amortization = EBITDA|
Operating income is calculated by taking the net profit from the interest, so both formulas work out the same. You can get all of the information for the EBITDA formula from your balance sheet and it is pretty easy to calculate. There is no legal duty to disclose this metric to shareholders. However, they can work it out for themselves from the publicly available financial data using the basic EBITDA calculation outlined above
The importance of keeping accurate financial records using high-quality accounting software cannot be underestimated. A mistaken input such as interest or tax can lead to an overvalued company. The penalties for inaccurate financial entry are severe.
What Is EBITDA Used For?
EBITDA is particularly useful when you need to distinguish between two companies. One company might have a super-efficient tax accountant in an easy jurisdiction. Another might have no outstanding loans. More might have little depreciation or amortization. But the EBITDA provides a way of distinguishing companies based solely on their operational performance. It can be used to decide which company is better or worse than another, even across jurisdictions and sectors.
When comparing two companies, potential investors will also look at the EBITDA Margin. The higher the margin, the more attractive the company, generally speaking. To get the EBITDA margin, you would simply divide the Total Revenue by the EBITDA
|Total Revenue / EBITDA = EBITDA Margin|
Let’s take two companies, A and B. Company A has an EBITDA of $700,000 and revenue of $7,000,000. It, therefore, has an EBITDA margin of 10%. Company B has an EBITDA of $900,000 and revenue of $18,000,000, for an EBITDA of 5%. Despite having a smaller total revenue and a smaller EBITDA, company A has a better EBITDA margin, demonstrating superior operational efficiency.
Aside from the EBITDA margin, we need to take the EBITDA Coverage Ratio into account. This demonstrates how well you can handle your debts and liabilities. The formula for the EBITDA Coverage Ratio is as follows:
|EBITDA + Lease Payments/Interest Payments + Principal Payments + Lease payments = EBITDA Coverage Ratio|
It’s best to take an EBITDA example to understand the concept a little better. Let’s examine an example company to determine the EBITDA, EBITDA margin, and EBITDA coverage ratio. The sample company has the following financials on its balance sheet:
- Total Revenue – $1.5 Million
- Net Income- $1 Million
- Interest – $15,000
- Tax – $37,500
- Operating profit – $97,500
- Depreciation – $15,000
- Amortization – $7,500
- Lease payment – $75,000
- Principal payment – $45,000
To get the EBITDA in this EBITDA example, you take your operating profit ($97,500) and add the depreciation ($15,000) and amortization ($7,500). This totals to an EBITDA of $120,000.
To calculate the EBITDA Margin, you divide the EBITDA ($120,000) by the total revenue ($1,500,000). This will give you an EBITDA margin of 8%.
To get the EBITDA coverage ratio, you combine the EBITDA ($120,000) with the lease payments ($75,000) and divide it by the combination of the interest payment ($15,000), principal payment ($45,000), and lease payment ($75,000). In this case, the EBITDA coverage ratio is 1.44. This is not a bad ratio, but it could be a little better. The company can handle its debts reasonably well but has no serious cushion to rely on.
EBITDA has a number of benefits for business people who know how to use it wisely. These include the following.
#1 – Clear Reflection of Operational Efficiency
This is probably the single biggest advantage of the EBITDA metric. By stripping away the interest, taxes, depreciation, and amortization, you can easily get a clear picture of how well a given business is managing its operations. Some businesses have great operational procedures and really poor management of debt and taxation. Some business models are experts in these areas and look for companies with excellent operations and poor administrative management to buy them out.
#2 – Great for Distressed Company Evaluation
EBITDA featured prominently in the 1980s as a tool to analyze whether or not a company could finance interest payments on debt. And it is still an excellent tool to do this. Banks still use it in order to ascertain whether or not a distressed business can repay a loan in the short term (1 – 3 years). It is ideal for leveraged buyouts and featured heavily during the dot.com crash.
#3 – Excellent for Business Comparison
As stated previously, EBITDA is a great tool for comparing two businesses. It eliminates financing and capital expenditures and leaves only the operations. Capital expenditures and financing can actually obscure how the company is really doing so the business will find it harder to conceal anything.
#4 – Useful for Technology and Research Companies
EBITDA is often showcased by early-stage technology and research companies. Amortization is often used to expense the cost of software investment as well as intellectual property. Some technology management teams propose that EBITDA is a more accurate representation of future profit growth trends, as it excludes capital expenditure.
#5 – Commonly Used & Reliable
EBITDA is not a ‘fringe’ or secret metric. It is commonly used and pretty reliable. Nearly all serious investors and business people will be familiar with it, even though it is not a GAAP metric. If you are talking to other investors or to financial personnel, they will be aware of it and you can talk to them about it. Because the EBITDA formula is easy to calculate, there is less room for confusion between negotiating parties. While it can be used to trick investors in some instances, business people are aware of the pros and cons.
Like all financial metrics, there are a number of potential pitfalls. If an investor fails to understand the limitations of any given financial metric, it will lead to erroneous decision-making. Warren Buffet is famous for his dislike of EBITDA and its shortcomings, which include the following.
#1 – Not a GAAP Measure
EBITDA is not a generally accepted accounting principle (‘GAAP’). This means there can be differences in the calculation from one company to the next. A company can emphasize the EBITDA in order to distract investors from net income and other more relevant metrics. If you notice that a company starts to report on EBITDA where it historically reported on net income, this is a giant red flag. It happens when companies borrow heavily or have rising development costs.
#2 – Ignores Working Capital & Cost of Assets
EBITDA operates as if working capital and the cost of assets are non-existent. EBITDA does not represent free cash earnings. There are costs outside of sales and operations that detract from profitability. Even if a company sells a product for a profit, what did it cost to first acquire the inventory? It also fails to recognize the cost of developing products.
#3 – Obfuscates True Company Value
EBITDA can easily make a given stock look cheaper than it really is. This is because stock price multiples of the EBITDA are lower than the stock price multiples of earnings. For instance, a stock might be trading at 8 times its EBITDA, a low multiplier indicating a good investment. However, the same stock could trade at 20 times its forecasted operational profits, painting a completely different picture.
Relationship to Other Financial Metrics
As with all things in accounting, you can only understand one metric in relation to all of the other metrics. They complement each other. Below are some of the most relevant metrics you need to comprehend before you ‘get’ the EBITDA:
- Adjusted EBITDA – This is similar to EBITDA but goes one step further and eliminates one-time irregular expenses in the calculation. These expenses do not have a bearing on the management of the company and the metric allows for easier comparison between companies in different jurisdictions and industries. It excludes a broad list of expenditures including 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, etc.
- Operating Cash Flow – Many believe this is a better metric to use in comparison to EBITDA, at least in terms of cash generation. It includes depreciation and amortization, which are non-cash, intangible charges. It also includes changes in working capital such as receivables and inventory. Investors that rely solely on EBITDA will miss vital clues on how a company handles its cash flow.
- Operating Income – This is also known as EBIT, which is similar to EBITDA. It is also similar to operating cash flow but does not include changes in working capital. It does include amortization and depreciation to give a more all-encompassing figure. It denotes earnings before interest and taxation.
- Total Revenue – This is also referred to as gross income. It is all the money you are taking in with your sales, and you can find it at the top of your profit and loss statement. Of course, understanding total revenue is meaningless unless you examine total expenditure.
- Net Income – This is the total revenue when all business expenses, including depreciation, interest, tax, and amortization, have been subtracted. You can find this at the bottom of your income statement.
- Cash Flow – Not the same as profitability. This is cash coming into the business as compared to the cash going out. But financial mismanagement can mean that a company has a positive cash flow but negative profitability. A business might have timing problems in relation to sales and accounts receivables. And if you pay late in the world of business, it comes with interest charges.
It is also useful to understand the EBITDA multiple. This multiple can be calculated by dividing your Enterprise Value (EV = Market Capitalization + Value Of Debt + Minority Interest + Preferred Shares) by the EBITDA. The EBITDA multiple indicates to analysts, M&A professionals, and financial advisors whether your company is either overvalued or undervalued
If your ratio is high, it means your company might be overvalued, while a low ratio indicates it’s undervalued. The benefit to the EBITDA multiple is that it takes company debt into account, which other multiples like the Price-to-Earnings ratio doesn’t consider
Ways To Increase EBITDA
There are multiple methods you can use to increase your EBITDA. Remember that you will be looking to paint a clearer picture to investors, not ‘hiding things’ so that more people will invest. A vital first step is to ensure you are using the best accounting platform you can find so your core values are accurate.
All financial forecasts are only as strong as the individual data points used. When your source data is correct, you can then look into recasting your EBITDA. This presents a more accurate picture of EBITDA value by amending previous financial statements (last 3 – 5 years) to include the following:
- Expenses From Unnecessary Assets – If you annually rent a country house for a company retreat, this is an expense that may not be picked up by a buyer.
- Owner Salaries & Bonuses – these will likely be greater than other employees, but will not be costs that a new owner must follow.
- One-time Fees – If you spent money on a legal dispute or a one-time marketing campaign, these are not ongoing costs that a buyer would have to take on.
- Repairs & Maintenance – Often, private business owners will categorize capital expenses like repairs to minimize taxes, but this hurts its valuation down the road by reducing your historical EBITDA.
Needless to say, you always want to look at ways to hire the best employees, market to the right market segment, cut expenditure, and maximize the customer experience. These will all reflect positively in terms of your EBITDA as they are simply good business practices. But they are outside the ambit of this article and are specific to your industry, jurisdiction, business size, and many more items.
EBITDA is a vital component for comparing two companies and as an indication of operational profitability. It forms the basis of three even more critical business valuation tools:
- EBITDA Margin Ratio
- EBITDA Coverage Ratio
- EBITDA Multiple
All three should be understood so you can more easily understand the true value of a given company or business. But in order to really make an accurate analysis, you will also need to investigate the limitations of EBITDA, where it is useful, and where it is simply misleading.
Finally, in order to assess any company, you need to use at least 20 or 30 financial metrics together to understand the complete picture. This is simply the nature of business and investment theory.