Jargon Busting – EBITDA
Ever wondered what all those financial terms your accountant uses but too afraid to ask? In this series we aim to demystify accounting jargon by explaining words and phrases in simple terms for anyone to understand.
This week we’re looking at EBITDA.
What is EBITDA?
EBITDA stands for “earnings before interest, taxes, depreciation, and amortization.” In simple terms, EBITDA measures a company’s profitability from operations. It looks at how much revenue is left over after paying for variable costs to operate the business, like wages, raw materials, and utilities.
EBITDA excludes interest, taxes, depreciation, and amortization because these are “non-operating” expenses. Interest and taxes are determined by a company’s capital and legal structure, not how well it is operationally run. Depreciation and amortization reflect a company’s choice of accounting methods and the age of its assets, not how much cash it is generating from operations.
By stripping out these non-operating expenses, EBITDA provides a cleaner view of a company’s core profit-generating ability. It helps investors evaluate and compare profitability across companies. If EBITDA is increasing over time, it usually means a company’s operations are improving and generating more cash that can be used to fund growth or pay down debt.
EBITDA is a rough proxy for cash flow, but it’s not a perfect measure. It ignores changes in working capital like increases or decreases in inventory, accounts receivable, and accounts payable. It also ignores capital expenditures required to maintain or grow the business. That’s why EBITDA should not be seen as a substitute for net income or cash flow. Rather, it’s a supplement that provides another perspective on the operational strength and performance of a company.
In summary, EBITDA is a useful measure of a company’s operational profitability. By stripping out non-operating expenses like interest, taxes, depreciation, and amortization, it provides a clearer picture of how well a company is generating cash from its core business activities. For non-accountants, EBITDA can help evaluate and compare the profit-generating power of companies to support investment decisions. But it should always be considered alongside other metrics like revenue, net income, and cash flow.
Why EBITDA Matters for Business Valuations
For business owners and investors, EBITDA provides an easy way to evaluate a company’s financial performance and compare it to similar businesses. Buyers will look at your EBITDA to determine how much they’re willing to pay for your company. The higher your EBITDA, the more valuable and appealing your business will be to potential buyers or investors.
- EBITDA ignores differences in capital structure. It focuses solely on a company’s operating profitability, so you can compare the earnings power of companies that may have different debt levels.
- EBITDA provides a more accurate picture of cash flow. By removing non-cash expenses like depreciation and amortization, it shows how much money is actually available to service debt and fund operations or growth.
- EBITDA allows for easy comparisons. You can compare the EBITDA of companies across the same industry to determine which ones are more efficient and profitable. This helps in determining a reasonable asking price for your business.
While EBITDA is a useful measure, it does have some limitations. It ignores the capital intensity of a business and the actual cash required to sustain operations. It also excludes the costs of assets like equipment that generate revenue. For these reasons, EBITDA should not be used alone, but rather along with other metrics to determine a business’s true value and financial performance.
For business owners, focus on improving your EBITDA by cutting unnecessary expenses, increasing sales, and running an efficient operation. The higher your EBITDA, the more interest you’ll receive from buyers, and the better valuation you’ll get for your company when it’s time to exit. Understanding EBITDA will help demystify the process of buying and selling businesses.
Calculating EBITDA Step-by-Step
Calculating EBITDA is actually quite straightforward:
- Step 1: Find the Net Income
Start with the net income, also called the profit after tax. This is the company’s total earnings (or loss) after all operating and non-operating expenses have been deducted. You can find this number on the company’s profit and loss statement.
- Step 2: Add Back Interest Expense
Next, add back any interest expense listed on the profit and loss statement. Interest expense reflects the cost of borrowing money and is considered a non-operating expense.
- Step 3: Add Back Taxes
Then, add the tax expense. Like interest, taxes are also considered a non-operating expense.
- Step 4: Add Back Depreciation and Amortization
Finally, add back depreciation and amortization expenses. Depreciation and amortization represent the loss in value of physical and intangible assets over time due to wear and tear and obsolescence. They are non-cash expenses, so they are added back.
In short, EBITDA aims to evaluate a company’s fundamental earning power before the influence of financial and accounting manoeuvres. It’s a more flexible metric for comparing companies with different capital structures and tax rates. For this reason, EBITDA is a popular valuation tool used by investors.
While EBITDA is useful, it does have some limitations. It does not account for capital expenditures like equipment or property, so it may overstate cash flow. It also ignores the depreciation of assets. For a full picture of a company’s financials, EBITDA should be considered along with metrics like net income, cash flow, and balance sheet data.