What is EBITDA and why is it important?

 

If you’re new to business — or even if you’re not — EBITDA (e-bit-dah) may look hard to pronounce, but it doesn’t have to be hard to understand. Once you become familiar with its meaning, variables and formulas, you’ll be speaking EBITDA in no time. Let’s get started.

 

What does EBITDA stand for?

EBITDA stands for earnings before interest, taxes, depreciation and amortization. It’s a metric for understanding a company’s financial performance and profitability. Stripping away extraneous factors such as interest, taxes, depreciation and amortization (the last four letters in the acronym) from total earnings provides a clearer, more accurate measure of a company’s cash flow — especially compared with that of competitors. 

Step one in understanding EBITDA is to break down the acronym into its pieces:

Earnings: The money your business brings in during a certain period, typically measured in months or quarters

Interest: The extra money you pay to lenders, in addition to the principal amount you borrowed

Taxes: The dues you pay to local, state or federal authorities as part of your business’s activities

Depreciation: Gradual reductions in the value of your existing tangible assets such as computers, Point of Sale (POS) systems, office supplies, inventory or other capital expenditures

Amortization: Similar to depreciation, but for intangible objects (think of reductions in loan payments over time or the worth of proprietary software)

 

Why is EBITDA important?

EBITDA can be useful in many ways. It offers different benefits to various types of business stakeholders.

 

It helps measure business success

Many nonoperating expenses — like taxes, interest payments and depreciation of tangible and intangible expenses — can vary greatly from year to year or between different businesses, industries and tax jurisdictions. This can make understanding your success difficult. EBITDA simplifies the process, allowing you to compare your raw earnings within your own business over time and gauge how you stack up against your industry peers.

 

It helps lenders evaluate risk

If you’re looking to purchase new equipment, expand your business or make any other capital investment, you may need a business loan or line of credit. Banks and other lenders often consider your company’s EBITDA when deciding whether your business is a risk they’re willing to take on. EBITDA is used to determine a company’s debt service coverage ratio, which shows potential lenders how well you’ll be able to repay the loan and meet other short-term obligations.

 

It gives investors valuations for buyouts

One of EBITDA’s main uses is for business valuation. Many potential investors use a variation of EBITA, known as the EBITDA multiple, to compare businesses within the same industry that are similar in size and scope. Comparing a business’s value with its raw earnings can help investors make acquisition decisions.

 

How do you calculate EBITDA?

Once you know your formula, calculating your business’s EBITDA is a fairly simple process. Before you get started, you’ll want to have your business’s current financial statements handy — specifically your income statement and balance sheet.

There are two common formulas for calculating EBITDA. Whichever formula you choose, be sure to stick with it as you continue to calculate your business’s EBITDA over time to ensure consistency.

 

What’s a good EBITDA?

There is no one-size-fits-all number for an ideal EBITDA. A “good” EBITDA depends on several factors, including industry benchmarks and your own business expenses and cash flow, but a few additional factors may come into play.

Overall, it’s tough to quantify what counts as a good EBITDA unless you know your competitors’ EBITDA as well as your own.

You can, however, evaluate your own EBITDA through what’s known as an EBITDA margin. And as you may have guessed, there’s a formula for that. 

 

What are some other variations of EBITDA?

Variations on EBITDA may be useful, depending on which aspects of your finances you’re trying to understand. You’ll want to identify the performance metric that best aligns with your business’s current financial situation.

Some common variations include:

• EBITDA multiple: To compare businesses for valuation processes, investors look to this metric that measures a company’s return on investment by analyzing a ratio of its enterprise value and annual EBITDA number.

• Adjusted EBITDA: To account for extraordinary and one-time expenses during a business valuation, valuators will often adjust the typical EBITDA to include items like nonoperating income, noncash expenses and litigation costs.

• EBT: Earnings before taxes measures a company’s operating performance before deducting income tax expenses but after the other expenses that EBITDA ignores.

• EBIT: Earnings before interest and taxes can help account for different interest rates businesses may pay, depending on their location and other factors. Unlike EBITDA, this calculation does not include the cost of depreciation and amortization from a business’s net profit. This measure of a company can help account for different interest rates businesses may pay, depending on their location and other factors.

• EBIAT: Earnings before interest after taxes. This calculation provides a simpler understanding of a business’s post-tax earnings before interest payments are factored in.

• EBITDAR: Earnings before interest, taxes, depreciation, amortization and restructuring/rent. This calculation adds to the classic EBITDA by including any costs associated with rent payments or business reorganization.

 

The bottom line

Even though EBITDA is a valuable metric, many investors are reluctant to use it as the sole measure of a company’s financial performance, since it doesn’t take several key expenses and important factors into account. These factors include copyrights, other intellectual property and changes in working capital. It’s important to note that EBITDA does not conform to generally accepted accounting principles.

One approach is to use EBITDA as part of a mix of several metrics to better understand your company’s financial health, along with cash flow and operating margins.

For more information on how to assess your business’s performance and optimize your operational capital, speak with a Chase business banker.