What is EBITDA?

EBITDA helps capture a company’s true profit... with all the fancy accounting footwork stripped away.

Once you add back in taxes, interest, depreciation, and amortization expense, you get a more rounded picture of the profitability of a company within the reported period. This calculation helps you better compare apples to apples when evaluating or comparing companies, public or private.

We have more acronyms for you to get to know. To calculate EBITDA, start with the operating profit, for a shortcut. The operating profit is also known as earnings before interest and tax (EBIT). Add back depreciation and amortization to EBIT (Earnings Before Interest and Taxes) to get the EBITDA.

An even simpler method is as follows: EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortization

The other formula is: EBITDA = Operating Income + Depreciation + Amortization

Let’s look at each of the components to break it down further.

• Net Profit: This is simply the net income after all the expenses. It’s the bottom line profit, and is found at the bottom of the income statement.
• Interest Expense: The interest charged on equipment and other items financed with debt. It varies among companies and is an expense found in the non-operating expense section.
• Taxes: Companies pay a percentage of their income in taxes. The figure changes annually and depends on each business, location, and size of the company.
• Depreciation and amortization: These costs indicate the cost of an asset (like machines in a factory or a truck for a courier) and the wear and tear from use during a period. These expenses appear on the operating expense section of the income statement.

One of the key reasons behind EBITDA’s prominence is that it shows higher profit figures than only operating profits. Companies in capital-intensive industries likely take on a lot of debt to finance themselves, so they often choose EBITDA as their preferred metric to share.

EBITDA helps investors and analysts get a fuller picture of what a company’s value is and assesses its potential worth — It helps cut the effects of government, financing, and accounting decisions out of the equation to give you a clearer view of the business.

Many businesses and investors use EBITDA to help determine their cash flow, and ultimately, an estimated valuation range for the company. Typically, valuations are placed and reported as annual multiples of EBITDA.

The interest coverage ratio, which is a profitability and debt ratio used to determine how well a company can pay the interest on its outstanding debts, is an important calculation.

Investors calculate the interest coverage ratio to determine the company’s ability to make interest payments on time. Most investors use this ratio to understand the company’s profitability and its risk. Investors want to see that the company can pay the bills without digging into its profits and not sacrificing its operations.

A creditor uses the interest coverage ratio to determine if a company can support additional debt. Companies that can’t pay the interest on the debt definitely cannot make the principal payments.

Interest Coverage Ratio = (Earnings Before Interest & Taxes)/Interest Expense

Analysts sometimes use a variation of EBITDA, the EBITDA margin, to better gauge the profitability of the company, as compared to its revenues. Here’s the formula:

EBITDA margin = EBITDA/Total Revenue

The above calculation determines the percentage of EBITDA against the company’s revenue. That margin indicates how much profit a business made in a year. A business with a larger margin than another is usually more appealing to investors since it may have more growth potential.

Let’s plug some numbers into the formula.

Company A has an EBITDA of $700K and a revenue of $7M. That makes their EBITDA margin 10%. Company B has an EBITDA of $650K and $8M in revenue. Apply the formula, and you’ll get 8% margin for Company B ($650K/$8M). If a prospective buyer had to weigh their options, they would probably choose Company A since it has a higher margin than Company B.

Most financial experts agree that the net profit margin is an essential indicator of the company’s financial strength — It helps determine how much profit each dollar of sales generates. EBITDA is different in the sense that it takes into account production and operation expenses, but adds back depreciation and amortization.

Here’s how you calculate it:

Net Profit Margin = (Sales - Cost of Sales - Operating Expense - Other Expenses - Interest - Taxes)/ Revenue x 100.

The point of adjusted EBITDA is to make it more evident to analysts or buyers if one business is a better investment than another. The difference between EBITDA and adjusted EBITDA are often small. But even so, it’s important to understand the distinction.

Standardizing income and cash flow and eliminating irregular expenses such as bonuses to owners makes it easier to compare businesses. Calculating the adjusted EBITDA is as easy as taking the above formulas, but goes a step further. That involves removing the cost of irregular and non-recurring expenses.

Here’s what’s excluded in adjusted EBITDA.

• Non-operating income
• Unrealized gains or losses
• Non-cash expenses
• Litigation expenses
• Asset write-downs
• Foreign exchange gains or losses
• Special donations
• One-time gains or losses
• Goodwill impairments
• Above-market owner’s compensation
• Share-based compensation

The first value you need to know in working out the EBITDA Multiple is the Enterprise Value (EV). You can calculate the EV by finding the sum of the following:

• Value of debt
• Common shares
• Minority interest
• Preferred shares

After you’ve tallied the total sum, subtract it from the cash and cash equivalents, which are your bank accounts, treasury bills, marketable securities, etc.

Here’s the formula:

EBITDA Multiple = Enterprise Value/EBITDA

You can take the formula a step further by using the Enterprise Value/EBITDA Multiple calculation. That ratio helps indicate to investors if the company is overvalued or undervalued. A high ratio means that your company could be overvalued (FYI, a low ratio means it’s likely undervalued). A key difference between the EBITDA multiple and Price-to-Earnings ratio is that the EBITDA Multiple considers debt while the Price-to-Earnings ratio doesn’t.

So, how do you know if an EV/EBITDA is healthy? Generally, anything below 10 is seen as healthy. The common way to determine the healthiest EV/EBITDA in a sector is by comparing the relative values of companies in the same industry.

The valuation of the company gets cheaper with a lower EV/EBITDA. The same applies to the Price-to-Earnings (P/E) ratio. Therefore, investors typically look for a low value. To give them extra comfort, conservative investors look for a low P/E ratio and EV/EBITDA, as well as steady dividend growth, for those companies that pay dividends.

There’s another term that’s helpful to nail down when understanding EBITDA: Operating Income. That’s what’s left after you subtract the profit from operating expenses, like depreciation and amortization. Operating income helps in analyzing a company’s core operations and expense management. EBITDA takes it a step further by helping indicate the company’s profitability. Investors should use both methods when valuing a business.

Some businesses want to know the total earnings of the company after accounting for all of their expenses. Other owners want to know the profit before expenses such as tax and depreciation. The major difference is between using depreciation and amortization. EBITDA calculates the company’s profit before paying interest and taxes and also taking depreciation and amortization into account. Meanwhile, net income calculates earnings after accounting for all expenses.

Yes. It’s known as recasting the EBITDA. You can amend your previously released earning statements for a specific reason. This may happen if an investor wants to account for more precise costs by inserting one-off earnings or expenses that would’ve otherwise been left out. This allows the potential buyer to get the most accurate number for the company’s worth and potential. You should not confuse this concept with manipulating the EBITDA.

Some factors that could be amended include:

• Revenue from unnecessary assets
• Owner salaries or bonuses, which are likely higher than all employees
• One-time fees such as legal disputes or marketing campaigns
• Expenses such as the owner not paying rent due to owning the building

Benefits:

• Commonly used: Many analysts and investors use EBITDA, making it a kind of a universal language in the business world.
• Eliminates unhelpful variants: It provides a good representation of the company’s operating performance by removing expenses including interest, tax, depreciation, and amortization.
• Easy to calculate: It’s easy to determine, as well as to combine with other formulas, making it simple for all parties to understand.
• It’s reliable: Any investors consider it a more reliable indicator of a company’s financial soundness, compared to other metrics.

Limitations:

• Excludes working capital: The calculation for EBITDA does not assess a company’s working capital and cash flow.
• Varying starting points: Companies might use different earnings figures as a starting point in calculating EBITDA.
• May obscure company evaluation: One of the major setbacks is that it can make a company look cheaper than it is.
• Could be manipulated: Companies can change their depreciation schedule in an effort to make profits and EBITDA appear better than what they actually are.
• Not regulated by General Accepted Accounting Practices (GAAP): This means companies may allow companies to interpret the formula in their own way.

A key reason companies calculate EBITDA is because it’s of interest to investors or lenders who may want to buy or loan money to a business. To benefit from either of those ventures, the investor, lender, or acquirer must have a good understanding of the company’s EBITDA. It helps investors determine how much the company has made in a specific period and allows financial institutions to analyze the profitability of a business.

It can be tremendously helpful to business leaders as well as potential buyers or investors to get the information they need to make the right investment decision.