EBITDA

What is EBITDA?

EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization, is a widely used earnings metric that is a variation on net income in evaluating the performance of a company.

It removes non-cash elements, like depreciation and amortization, providing a more accurate measure of a company’s cash flow and operating performance. It normalizes a company's results and can be especially useful when comparing the valuation of different companies.

It is common for public companies to report this metric in their quarterly results, along with adjusted EBITDA. Adjusted EBITDA removes various irregular, non-recurring items from EBITDA.

To further elaborate, the components include:

• Earnings. After all operating expenses, earnings are the net income of a business.
• Before. This portion simply means “earnings before.”
• Interest. This is the interest paid to lenders for a company’s debt, such as the interest payments of bank loans.
• Taxes. These include local, state, and federal income taxes paid as part of the company’s business activities.
• Depreciation. This non-cash expense is the gradual reduction in the value of existing fixed assets like inventory or computer equipment.
• Amortization. Also a non-cash expense, this is the write-down of intangible assets. It is similar to depreciation but applies to intangible assets like trademarks or patents.

Again, it is essential to note that this is not a metric used by Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) in the U.S.

What does EBITDA measure?

EBITDA measures operating profit from the core operations of a business prior to the impact of taxes, non-cash expenses, and debt. It is an alternate metric of profitability to net income.

Many non-operating expenses — like interest, taxes, and depreciation of intangible and tangible expenses — can significantly fluctuate from year to year and business to business. Therefore, stripping away such elements and comparing crude earnings over time helps companies better measure success and how well they are performing compared to similar companies that are industry peers.

What types of taxes are included?

The taxes included in EBITDA are any local, state, or federal income taxes imposed by tax authorities, and the business must pay them as part of its activities.

Why is EBITDA important?

EBITDA is crucial because it is widely used to assess a company’s financial performance and capacity to generate cash flow. It removes the impact of many non-operating expenses, like taxes and interest expenses, and focuses on the company’s operating performance and profitability to better reflect its financial health.

Because this metric normalizes a company's results, it can be beneficial for owners, stakeholders, and investors when comparing the valuation of different entities and how well the company is performing compared with industry peers.

As noted, EBITDA is commonly used in business valuation because it provides valuable insights into financial performance. However, it has its pros and cons.

The pros of using EBITDA

One of the main advantages of EBITDA is that it provides a good assessment of a company’s profitability and growth. Additional pros include: 

• It is capital structure neutral, meaning that it removes the impact of a company’s capital structure.
• When comparing two companies, each one may have differing tax rates due to geographic location or legal structure. Using it eliminates the impact of income taxes.
• Given that this metric excludes the impact of depreciation and amortization, it normalizes non-cash accounting constructs. This normalization can prove beneficial as such non-cash-accounting constructs do not reflect a company’s ability to generate cash flow and are not standard across the board.
• It smooths out short-term fluctuations in working capital by removing variations in net working capital from period to period.

The cons of using EBITDA

There are several disadvantages to using EBITDA; it does have its limitations despite being a widely used metric. Some of the vital limitations are:

• It is not a metric in use by GAAP or IFRS in the U.S. As a result, critics argue that it is more subject to manipulation.
• It does not take into account changes in working capital.
• It does not consider copyrights and other intellectual property, which can be a downfall for companies with significant amortizable intellectual property. 
• It excludes tax liabilities and interest, which can be major expenses for businesses. Excluding such expenses can inaccurately portray a company as having greater profitability than it actually does.
• For entities with significant depreciable assets, adding back deprecation can result in a misleading measure of earnings.

Given the disadvantages and limitations of EBITDA, it should not be the only measure used when evaluating a company’s financial performance — especially for companies looking to sell, since it excludes income tax, working capital needs, and depreciation costs.

How do you calculate EBITDA?

There are two commonly used formulas for calculating EBITDA. Each formula essentially arrives at the same result; however, one formula is based on net income — operating income minus non-operating expenses — while the other is based on operating income. The two formulas are:

• Net income + interest + taxes + depreciation + amortization = EBITDA
• Operating income + depreciation + amortization = EBITDA

Alternatively, it may prove helpful to use an EBITDA calculator. 

Often used in the valuation of a business, operating income and EBITDA are important calculations. It is advisable to use operating income when analyzing a company’s production efficiency.

Consider the following net income example to further illustrate how the first formula works.

Company A is looking to determine its EBITDA. In looking at its income statement, it can find the necessary information. The company has reported a net income — earnings — of $40 million, and interest expenses total $10 million. It also has $8 million in taxes, while depreciation and amortization expenses total $20 million.

In this scenario, $40 million (net income) + $10 million (interest) + $8 million (taxes) + $20 million (depreciation + amortization) = $78 million EBITDA.

Now, consider the following operating income as an example using the second formula.

Company B is looking to make an acquisition. It has identified two potential acquisition targets but wants to examine their income statements to determine which has a higher EBITDA.

The first acquisition target reports the following:

• Operating income: $2,000,000
• Depreciation: $150,000
• Amortization: $50,000

Employing the operating income formula, $2,000,000 (operating income) + $150,000 (depreciation) + $50,000 (amortization) = $2,200,00 EBITDA.

Company B then reviews the income statement for the second acquisition target. The second acquisition target reports the following:

• Operating income: $1,500,000
• Depreciation: $250,000
• Amortization: $75,000

In this example, $1,500,000 (operating income) + $250,000 (depreciation) + $75,000 (amortization) = $1,825,000 EBITDA.

Based on these findings, Company B decides to acquire the first company because it has a higher metric than the second company.

What is a good EBITDA margin?

The EBITDA margin is a profitability ratio that measures income generation relative to revenue. While several factors — such as industry and company size — must be considered, a margin of 10% or more is generally considered good. Publicly traded entities tend to have average margins in the low teens. Typically, the higher the margin, the better.

While a lower margin implies challenges with a company’s profitability and cash flow, a higher margin indicates lower operating expenses relative to total revenue. A good margin is relative, so measuring margins against competitors can be helpful in evaluating a company’s performance.

How do you calculate EBITDA margin?

The formula to determine the EBITDA margin is:

• Calculated EBITDA / total revenue = EBITDA margin

For example, if a company’s EBITDA for last year was $800,000 and it reported $10,000,000 in annual revenue, the margin would be 8% ($800,000 divided by $10,000,000).

Can EBITDA be negative?

Companies can have negative EBITDA. It implies that a company has cash flow problems and its operating expenses exceed revenues. However, it is essential to better understand the reasons behind a negative EBITDA, as it doesn’t automatically mean that an entity is destined to fail.

Reasons for negative EBITDA can include:

• Industry cycles, periods of slowdown, or operating in a cyclical industry
• Hefty startup costs like marketing, hiring, and product development
• Operational inefficiencies such as outdated technology, mismanagement, or inadequate cost controls

Are EBITDA and operating income the same?

While they are both important measurements used to calculate a company's income and profitability, EDITDA and operating income are not the same. There are notable differences between them.

EBITDA is an earnings metric that measures an entity’s overall revenue before interest, depreciation, taxes, and amortization.

Also known as operating profit or earnings before interest and taxes (EBIT), operating income measures an entity's income through its operations. It is the revenue that remains after deducting a company’s operational direct costs — merchandise, labor, materials and supplies, etc. — and indirect costs — rent for a facility, maintenance and depreciation expense of equipment, etc. — from sales revenue.

What is the difference between EBITDA and adjusted EBITDA?

The difference between the two metrics is that EBITDA provides a brief overview of an entity’s operational profitability, excluding non-operating expenses. On the other hand, adjusted EBITDA can better reflect a company’s sustainable earnings by eliminating non-recurring, irregular, and one-time items — such as restructuring charges, one-off expenses, etc. — that may misconstrue EBITDA.

It is common for public companies to report both metrics in their quarterly results, which can provide a more comprehensive view of the company’s ongoing earnings capacity.

Understanding a company's EBITDA and adjusted EBITDA is beneficial since they help business owners and other stakeholders better understand growth prospects, financial performance, and potential risks.