EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a measurement of a firm’s revenues with interest payments, taxes, depreciation, and amortization added back in. It allows investors to compare the financial position of different companies without regard to the effects of accounting decisions, business loans, and state/local tax rates.
In this article, we’ll explain what is EBITDA, how to calculate EBITDA, the different contexts in which EBITDA is used, and how to improve your company’s EBITDA.
Formula for Calculating EBITDA
There are two ways to calculate EBITDA:
(Formula 1) EBITDA = Net Income + Taxes + Interest + Depreciation + Amortization
In this first approach, the calculation starts from net income where the firm’s expenses have been already been deducted. To arrive at EBITDA, tax bills, interest payments, depreciation expenses, and amortization expenses will have to be added back to net income.
(Formula 2) EBITDA = EBIT/operating profit + Depreciation Expense + Amortization Expense
Alternatively, if you starting your EBITDA calculation with operating profit, also known as EBIT (revenue minus cost of goods sold and operating expenses but not taxes or interest), then you would add depreciation and amortization expenses to get EBITDA.
Here’s an example of how you calculate EBITDA using the information on your income statement:
|Gross Revenue||$ 3,500,000|
|Cost of Goods Sold (COGS)|
|Gross Profit (Gross Revenue - COGS)||$ 3,350,000|
|Earnings before Interest and Taxes (EBIT) (Gross Profit - Operating Expenses)||$ 2,540,000|
|Interest Expense||$ 10,000|
|Operating Income||$ 2,530,000|
|Net Income/Profit||$ 1,726,000|
Using this example and the first formula above, here’s how EBITDA would be calculated:
EBITDA = Net Income + Taxes + Interest + Depreciation + Amortization
EBITDA = $1,726,000 + $804,000 + $10,000 + $60,000 + $50,000 = $2,650,000
Key Concepts to Understand EBITDA
EBIT (earnings before interest and taxes) is an income statement item that shows the amount of revenue after deducting operating expenses. Stated another way, it is net income with interest and taxes added back in.
Operating expenses are expense items in the income statement directly related to the firm’s operations for the period. This includes depreciation and amortization expenses as well as items like rent and salary.
Depreciation is an operating expense found in the income statement. Every year, fixed assets like buildings, machinery, and vehicles decrease in value because they deteriorate with use. Depreciation is the part of a fixed asset’s value that is removed to recognize wear and tear.
Amortization is an operating expense found in the income statement. It is similar to depreciation, except that this is used to assess the useful value of intangible assets like goodwill, patents, trademarks and copyrights. Amortization is the portion of an intangible asset’s value that is removed to recognize its diminishing effectiveness as an asset to the firm.
Net income is the final line item in the income statement. This is where all of the firm’s expenses for the period have been deducted from the revenue.
Interest is an expense item in the income statement not directly related to a firm’s operations. It is the amount of interest payable for any business loans or other loans taken out during the period of time reflected in the income statement.
Taxes are also a non-operating expense that reflects the firm’s federal, state, or local tax obligations. They are computed by applying the appropriate tax rate to business income after removing allowable deductions.
Analysis of EBITDA
The higher a firm’s EBITDA, the more favorable it is to the firm’s overall financial position. EBITDA tells the total cash inflow a firm has received for an accounting period so a higher EBITDA means that a firm has more cash available to cover its expenses.
However, it should be noted that while EBITDA can be a short cut for cash flow computations, it is not a substitute. Cash flow considers changes in working capital (cash available for day to day operations) and capital expenditures, while EBITDA does not.
Applications of EBITDA
Financial analysts use EBITDA to test a firm’s solvency and liquidity.
The following applications and ratios use EBITDA for financial analysis:
EBITDA margin is the result of taking EBITDA and comparing it as a percentage of a firm’s total revenue. By dividing EBITDA by total revenue, financial analysts are able to compare the profitability of companies in different industries and of different sizes. Unlike other margin profitability ratios that measures the firm’s ability to turn sales into profit, the EBITDA margin is used as an overall assessment of a firm’s operating performance.
EBITDA to Interest Coverage Ratio
This determines if a firm has enough cash to pay off its interest liabilities for an accounting period. A ratio greater than 1 indicates that a business can sufficiently cover its interest liabilities for an accounting period.
EBITDA to Sales Ratio
Also called EBITDA margin ratio, this indicates what percentage of earnings will remain after a firm settles its operating expenses. A high level tells creditors that the business is able to control its operating expenses.
Debt to EBITDA Ratio
This is a metric used to determine a firm’s capacity to cover its debts. It’s calculated by dividing total debt by EBITDA, and the resulting number tells you how leveraged a company is, which can be helpful on its own or when comparing to industry norms.
Net Debt to EBITDA Ratio
This is a measure that tells how long it will take for a firm to pay its liabilities, assuming that net debt and EBITDA remain constant. A lower result means there’s more cash available to cover liabilities.
EV (Enterprise Value) to EBITDA Ratio
Also called enterprise multiple or EBITDA multiple, this ratio measures a firm’s value by dividing the enterprise value by EBITDA. Enterprise value is equal to the total of market capitalization, debt value, minority interest, and preferred shares, minus cash and cash equivalents. A high or low ratio tells if a firm is over or undervalued, respectively.
Advantages of EBITDA
- EBITDA offers a more accurate view of a firm’s operational performance because it disregards expenses, such as taxes and interest, which are not the actual results of operations.
- EBITDA nullifies the effect of accounting decisions, such as the use of different depreciation and amortization methods.
- EBITDA nullifies the effect of governmental decisions resulting in different tax burdens based on company size, industry, and location..
Disadvantages of EBITDA
- EBITDA is not a substitute for cash flow because it does not recognize the changes created by the day to day use of cash in a firm’s operations.
- EBITDA can overstate a firm’s ability to satisfy its interest liabilities because it ignores expenses from non-cash items (depreciation and amortization).
- EBITDA works on the flawed assumption that expenses from non-cash items are avoidable and should be ignored. For example, depreciation is ignored because the firm doesn’t exactly shell out cash when declaring depreciation expense.This results in a firm that may be unprepared to upgrade or replace assets.
- If a business records revenue even before it is earned, or inaccurately records cost or expenses, the EBITDA figure won’t be reliable.
How to Improve EBITDA
Manage budget and expenses for miscellaneous items
The best way to improve your firm’s EBITDA is to review and manage expenses and be smarter about what you spend money on. For example, be strict about travel and entertainment expenses. Review vendors and suppliers who you are currently paying, and assess whether you can eliminate or reduce the cost.
Reduce personnel costs
For most companies, the largest expense by far is staffing. It can account for 60 % of a business’ expenses. One way to improve EBITDA is to reduce personnel costs. You can do this by using freelancers or contract labor for one-off or simpler tasks. You can also automate things to save money–for example, using payroll software to handle certain HR functions costs a fraction of full-time HR staff.
Manage your inventory
Unsold products represent operational expenses and can have a negative effect on your EBITDA. You don’t want to order more product than you can sell. Evaluate your firm’s policies on inventory management to keep unsold goods at an acceptable level.
Try to sell higher margin goods or services
If reducing expenses is one way to improve your EBITDA, increasing your earnings is another. One way to increase business revenues is by selling higher margin goods or services. This doesn’t necessarily mean you have to change your business model. You can add to your existing product or service line by offering, for example, customized goods and services, higher value add ons, and bundles of products and services.
Used properly, earnings before interest, taxes, depreciation and amortization (EBITDA) is a very useful tool to know how well your business is performing relative to other companies. Understanding what is EBITDA and the factors that affect EBITDA will help you plan ahead and improve your bottom line.