How valuable is your business? Whether you're applying for a business line of credit, looking for investors, or trying to determine your ability to pay down debts, performing a financial analysis is key.
A common tool used by financial analysts and investors is EBITDA. It's a financial measure that gives them an idea of a business' value and efficiency. We'll take a deeper look into this financial measure, and learn how it's used.
What Is EBITDA and What Does it Stand For?
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It's a margin that gives investors a short-term picture of a business' operational efficiency. It's a term that's interchangeable with earnings or income.
It's not regulated by the generally accepted accounting principles (GAAP), which is a common set of standards and procedures that accounting professionals follow. Due to this, EBITDA is not typically calculated by businesses that create their financial statements following GAAP.
The core purpose of EBITDA is to compare profitability across different industries and businesses. It's used most often by investors or analysts who are evaluating a company's financial performance. It doesn't provide a full overview of a company's performance, so it's often used in conjunction with other financial statements and ratios to provide a clearer picture of its financial standing.
EBIT vs. EBITDA
EBIT stands for earnings before interest and taxes. EBITDA stands for earnings before interest, taxes, depreciation, and amortization. With EBIT, only interest and taxes are added back to net income. And with EBITDA, interest, taxes, depreciation, and amortization are added to net income.
Net income and EBITDA shouldn't be confused with one another -- the two terms are not interchangeable.
Net Income vs. EBITDA
Net income and EBITDA are not the same. EBITDA is net income with interest, taxes, depreciation, and amortization added back to it.
Next, we'll take a look at the EBITDA formula and learn how to perform the calculation.
EBITDA is calculated using the following formula:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
Here are the components that are used in the EBITDA formula:
This term is interchangeable with net income or net profit. It's the profit that's found at the bottom of a business' income statement.
The amount of interest will vary depending on how much money the company has borrowed to fund its business activities.
This value is the amount of taxes a business pays for the year.
4. Depreciation and Amortization
The depreciation and amortization amounts are found on the cash flow statement. And depreciation is the reduction in a fixed asset's value over the time an asset is used.
How to Calculate EBITDA
EBITDA is calculated by adding interest, taxes, depreciation, and amortization back to net income. And the net income amount is found at the bottom of the company's income statement.
For example, let's say Hannah's Cooking Supply Store earned $150,000 in total revenue. And the store's expenses were as follows:
- Rent: $12,000
- Utilities: $5,000
- Cost of goods sold: $50,000
- Interest: $8,000
- Taxes: $5,000
- Depreciation: $25,000
And the total net income for Hannah's Cooking Supply Store is $45,000. EBITDA would be calculated as follows:
EBITDA = $45,000 (Net Income) + $8,000 (Interest) + $5,000 (Taxes) + $25,000 (Depreciation and Amortization)
EBITDA = $83,000
The EBITDA margin formula is: EBITDA margin = EBITDA/Total Revenue. This shows the company's earnings before interest, taxes, depreciation, and amortization as a percentage of total revenue. The margin measures how much cash profit a company made within the year.
Using our previous example, Hannah's Cooking Supply Store, we'll calculate the EBITDA margin. Total revenue was $150,000 and EBITDA was $83,000
EBITDA Margin = $83,000 (EBITDA) / $150,000 (Total Revenue)
EBITDA Margin = $0.55 or 55%
The ratio shows that for every dollar of revenue, Hannah's Cooking Supply Store generates $0.55 in profit before taxes, interest, and depreciation and amortization are paid. The resulting percentage, 55%, can be used to compare the business' profitability to the profitability of other companies.
Adjusted EBITDA is a financial measure used to account for any irregular gains or losses. It's used for valuation purposes by investment bankers and financial professionals. For example, adjusted EBITDA would be used to value a business if any mergers and acquisitions are occurring.
Depending on the business or industry, the adjustments made to EBITDA will vary. These are a few of the most common items that can be adjusted for:
- Non-cash expenses
- Non-operating income
- Unrealized gains or losses
- One-time gains or losses
- Foreign exchanges gains or losses
- Litigation expenses
Next, let's dive into a few financial ratios that feature EBITDA.
EV/EBITDA (EBITDA Multiple)
The EV/EBITDA ratio compares a company's enterprise value to its earnings before interest, taxes, depreciation, and amortization. The main purpose of this ratio is to compare the value of different businesses.
EV/EBTIDA is calculated by dividing EBITDA from a business' enterprise value (EV). Enterprise value is the firm's debt plus equity, minus cash and cash equivalents.
The EV/EBITDA ratio is used to value companies. It's best to value mature, stable companies with low capital expenditures. Once the formula is calculated, you can compare the values for different businesses.
EBITDA Coverage Ratio
The EBITDA coverage ratio is used to determine a business' ability to pay off its liabilities related to loan and lease obligations. Here is the EBITDA coverage ratio formula: (EBITDA + Lease payments) ÷ (Loan payments + Lease payments).
This ratio is calculated by adding lease payments and EBITDA then dividing the total by the sum of loan and lease payments. The EBITDA coverage ratio is used to determine how able a company is to pay off its long-term obligations in a timely manner.
Debt to EBITDA
The debt to EBITDA ratio, also known as the net debt to EBITDA ratio, is calculated by dividing a business' net debt by EBITDA. This ratio is used to determine a business' ability to pay off its debt. And the lower the ratio, the better.
Net debt is calculated by adding short-term and long-term debt and dividing it by the sum of a business' cash and cash equivalents. A low debt to EBITDA ratio means the business isn't in much debt and is more likely to pay down its financial obligations. If the business has a higher debt to EBITDA ratio, it's in more debt.
EBITDA and EBITDA ratios are tools for businesses and financial professionals to value a company and evaluate its profitability. To learn more about small business accounting and finance, read about calculating operating income next.
This article does not constitute legal advice. The steps required to calculate EBITDA may differ for each business, so you should seek your own legal advice to ensure you follow the correct process.