Understanding your business’s financial health and operational efficiency is immensely important for any business owner, whether you’re heading up a Fortune 500 company or still in the early days of a start-up. EBITDA is a simple tool for evaluating the financial viability of a company, while it’s also an effective way to compare the performances of two or more businesses with different capital structures or tax rates. Want to find out more? Explore the importance of the EBITDA formula for financial management with our simple guide.
What is EBITDA?
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Put simply, it’s a formula used to measure the financial health of your business. It’s closely related to the EBIT formula (earnings before interest and taxes), but because EBITDA removes the arbitrary or subjective factors that business owners have more discretion over, such as debt financing or methods of depreciation, it gives you a greater insight into financial performance without adjusting for capital structure.
Before you get started with your EBITDA calculation, you’ll need to know a little more about the terms behind the acronym. Here’s a quick rundown of the accounting terminology you’ll need to get to grips with if you want to learn how to calculate EBITDA:
Earnings – Your business’s net income, or profits, otherwise understood as the amount that’s left over from your income after you deduct expenses, production costs, and so on.
Interest – Expenses paid against any monies you’ve borrowed to finance your company.
Taxes – The money your business pays in corporation tax, and any other business-related taxes.
Depreciation – The extent to which your assets have declined in value over the course of their useful life.
Amortization – Expenses associated with intangible assets over a specific period of time.
How to calculate EBITDA
To calculate EBITDA, you’ll need to use the following EBITDA formula:
EBITDA = Net profit + Interest + Taxes + Depreciation + Amortization
To understand how this works in practice, let’s take a real-world example. Say Company A has a net income of $150,000, pays around $20,000 in taxes, has interest expenses of $10,000, and depreciation/amortization costs of $30,000, you can work out their EBITDA like so:
EBITDA = $150,000 + $20,000 + $10,000 + $30,000 = $210,000
What are the benefits of EBITDA for financial management?
EBITDA provides business owners with a clear understanding of their company’s value, as well as their worth to potential investors. Because it removes arbitrary/subjective factors like taxes and depreciation, performing an EBITDA calculation is a great way to evaluate your business purely on the strength of your core business operations, which many people claim is a clearer reflection of operational efficiency. In other words, the EBITDA formula levels the playing field between companies within different industries or sectors, allowing you to compare your performance more accurately.
So, what does that all mean for financial management? Well, aside from being a great valuation metric, the EBITDA calculation can be an insightful way to approach your company’s financial health and performance based solely on ongoing operations. This makes it a great tool for determining your company’s potential profitability, beyond the variables associated with financing and capital investment.
Limitations of the EBITDA calculation
Although EBITDA can provide you with an excellent top-line assessment of your business’s financial health, there are a few drawbacks that are worth considering.
In some senses, EBITDA provides an incomplete picture of your business’s finances. It doesn’t take into consideration the quality of earnings, the cost of assets, or the cash required to fund working capital, while EBITDA can also make it look as if your company has more money than it really does to pay back interest. Paradoxically, EBITDA can sometimes make your company look less valuable than it really is, which is why it’s so important to pair it with other financial metrics when assessing your business’s value.
Furthermore, EBITDA ignores intangibles (non-physical assets such as patents, trademarks, and brand recognition), which are becoming an increasingly important element in the valuation of businesses. It’s also worth noting that the EBITDA calculation does not form part of the generally accepted accounting principles (GAAP) that are used throughout the accounting industry in the United States, which may become relevant if your company does business with the US or you’re looking to expand.
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