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EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortisation. It is one of several metrics used to calculate and assess the financial health and earning power of a business.
In this post, we explain what EBITDA means, how to calculate it, and the various ways it is used by business owners, investors, and financial analysts to evaluate a firm’s performance.
What does EBITDA mean?
First gaining popularity in the 1980s during the leveraged buyout boom, EBITDA today is a common measurement of the operating performance and profitability of a business over a certain period.
EBITDA is used to calculate how much money a business earned in a particular period before taxes and other non-operating expenses were deducted.
Due to the variable nature of interest, taxation, depreciation, and amortisation expenses, EBITDA provides a more accurate picture of a company’s internal financial health and ability to generate cash from day-to-day operations.
Ordinarily, you deduct both non-operating and operating costs from gross profit to get the net profit, but EBITDA reverses part of this by adding the non-operating expenses back to the net profit. This gives you a better idea of the company’s underlying profitability for a certain period.
Before we look at the EBITDA calculation, it’s important to understand each of the terms in the acronym.
The starting point of the EBITDA formula, ‘earnings’ refers to the net income (profit) or net loss of a business in a specific period. This is the total revenue generated from sales minus all business expenses and costs.
Interest that the business pays on its outstanding debts, such as interest applied to mortgages, loans, overdrafts, credit cards, and supplier credit.
The various taxes that a company pays to HMRC, such as Corporation Tax and VAT.
Depreciation is a non-cash expense that spreads the cost of a fixed (tangible) business asset over the course of its useful life, rather than recording the full cost when it is purchased. This is most often used for equipment that gradually reduces (depreciates) in value over several years.
Another type of non-cash expense, amortisation is the process of gradually writing off the cost of intangible (non-physical) business assets over a specific period of time.
How to calculate EBITDA
There are two formulas that you use to calculate EBITDA. One is based on a company’s net income, whilst the other is based on its operating income.
The EBITDA formula based on net income is:
- Net income + taxes + interest expenses + depreciation + amortisation = EBITDA
The EBITDA formula based on operating income is:
- Operating income + depreciation + amortisation = EBITDA
You can usually find all of the information required to calculate EBITDA in a company’s profit and loss account (income statement) and balance sheet.
Fictional Company LTD wants to know its EBITDA. It refers to the profit and loss account and obtains the following figures:
- Net income: £100,000
- Interest: £5,000
- Taxes: £16,000
- Depreciation: £3,000
- Amortisation: £1,000
The company adds all of these expenses to the net income figure using the following calculation:
- EBITDA = £100,000 + £5,000 + £16,000 + £3,000 + £1,000 = £125,000
Fictional Company LTD determines that its earnings before taxes, interest, depreciation, and amortisation are £125,000.
How is EBITDA used?
Whilst EBITDA is not regulated by UK GAAP (Generally Accepted Accounting Principles) as a measure of financial performance, it is widely used and can provide valuable insight for business owners, finance experts, investors, and lenders.
Assessing operational performance
By removing variable factors like interest, taxes, and investment in key assets, EBITDA provides a clearer view of operational performance and efficiency based solely on the strength of core business activities.
This is particularly useful for companies with high startup costs, such as tech firms, or established businesses that have recently invested in expensive capital assets. Excluding these business expenses presents a fairer picture of operational efficiency and long-term earnings potential.
Cash flow proxy
Since EBITDA excludes certain variable expenses, it is often used as a proxy for a company’s operating cash flow. This can help when assessing the ability of a business to generate cash internally.
Executive decision making
Business owners and managers often use EBITDA to inform their decision-making with regard to operational efficiencies, the allocation of funds, investment in new equipment, borrowing options, and the future growth of the business.
EBITDA can provide a quick estimate of a company’s value, which can be useful for owners, accountants, and investors. It can also serve as a guide during sale negotiations.
Informing lending decisions
When assessing credit risk, lenders often use EBITDA to understand a company’s capacity to generate cash flow and determine its ability to make debt payments.
EBITDA facilitates competitive benchmarking with relative ease, enabling business owners and investors to compare the performance and profit potential of similar companies, as well as those operating in different industries.
Evaluating investment opportunities
The EBITDA metric is a shorthand way for investors to determine the core cash earnings and growth potential of a firm, particularly in comparison to other companies, by focusing on the underlying profitability of business operations.
It is a useful tool for evaluating the suitability of potential investment opportunities and making easy comparisons of firms across different industries.
Thanks for reading
By removing certain variables, EBITDA is a useful metric for quickly evaluating the operational performance and underlying profitability of a business. However, like most areas of financial analysis, relying on just one metric is not advisable.
When used alongside other key performance indicators, EBITDA can provide valuable insight into the financial health of a business and its ability to generate cash.
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