Earnings before interest, taxes, depreciation, and amortization (EBITDA) is a common way to measure a business’s profitability. This metric is one of several financial calculations that give both owners and potential investors a picture of the financial health and value of a business.
This article will discuss EBITDA, how it’s calculated, and what it means for you as an investor.
- EBITDA stands for “earnings before interest, taxes, depreciation, and amortization.”
- It measures a business’s operating income without including other types of income and deductions.
- Both business owners and investors can use EBITDA as one of several ways to evaluate a business’s profitability and overall financial health.
- EBITDA does not reflect cash flow nor does it fall under generally accepted accounting principles (GAAP).
Definition of EBITDA
EBITDA, which stands for “earnings before interest, taxes, depreciation, and amortization,” is a calculation to find the income from the operations of a business by separating this income from non-operations variables. To understand this metric, which can better reflect the operating profitability and financial health of a business, it’s important to take a closer look at each component of the acronym.
Earnings is the same thing as net profit or net income of a business. It’s income minus expenses and includes earnings from all types of sources.
Operating income is the income a business receives from its primary activities of selling products or providing services. This figure is shown on a business’s income statement (profit and loss statement) as “net income,” the income after gross profits (profits from operating activities).
The Variables of EBITDA
The four variables are usually shown in two sections on a financial statement—interest expense and taxes, then depreciation and amortization.
- Interest: Interest expense is the cost of using money that was borrowed for business activities. It can be interest on a business loan or business investment.
- Taxes: Taxes for EBITDA are the taxes paid by businesses, including income taxes, excise taxes, and employment taxes (Social Security and Medicare taxes and unemployment taxes).
- Depreciation and Amortization: Depreciation and amortization are terms used to describe the process of deducting costs of buying and using long-term assets that a business uses to make a profit. A business deducts these costs over a period of time, depending on the type of asset. Depreciation is the deduction process used for tangible assets like vehicles, buildings, machinery, and equipment. Amortization is used to deduct the costs of intangible assets, those with no physical form, like copyrights, trademarks, and patents.
How Do You Calculate EBITDA?
Here is the formula for calculating EBITDA:
EBITDA = Net Income + Interest Expense + Taxes + Depreciation + Amortization = Net Income from Operations.
The table below outlines an example of EBITDA calculation.
|Provision for income taxes||$ 15,000|
|Net interest expense||$ 5,000|
|Depreciation and amortization||$ 8,000|
What EBITDA Means for Individual Investors
Investors can compare the EBITDA information for several businesses as part of their analysis for investment purposes. It enables them to look at companies based solely on their operations, excluding the impact of taxes, amounts of debt, and the cost of their capital investments.
It answers the question, “Which company is best at generating income?” If investors are looking at several businesses of different types, they can rank them by their EBITDA to see which company is best able to turn sales into profits.
EBIT counts interest expenses and potential tax expenses but doesn’t include depreciation and amortization, the costs of investing in capital assets.
Limitations of EBITDA
While EBITDA can be useful in determining profitability, there are still certain limitations in using the metric. For instance, EBITDA doesn’t reflect cash flow, which is another important measure for businesses. Cash flow is the inflow and outflow of cash to and from a business reported on a cash flow statement.
EBITDA also isn’t included as a measure of net income as required for generally accepted accounting standards (GAAP). You may see “non-GAAP” on an EBITDA calculation, recognizing that this term doesn’t follow the standards.
Frequently Asked Questions (FAQs)
What is adjusted EBITDA?
Some businesses include a calculation adjusting EBITDA for:
- Unusual charges
- Share-based compensation for executives
- Losses in paying off debt
- Income or loss from discontinued operations (closing locations, for example)
These are special circumstances that may have a one-time or short-term effect on the earnings of the business.
What is EBITDA margin?
Margin, sometimes called margin of safety, is used in accounting to calculate a company’s sales compared to its profit. Investors use margin to evaluate potential investments for potential losses and determine the best price for a stock that is trading at a price lower than its intrinsic value.
EBITDA margin is just one of many ways investors evaluate margin of safety.
What is a good EBITDA multiple?
Multiples are ratios used to compare potential investments that investors may be considering. Some typical EBITDA multiples are:
- EBITDA compared to sales
- EBITDA compared to sales, general, and administrative (SG&A) expenses
- EBITDA compared to research and development (R&D) expenses
To know if an EBITDA multiple is good, you must look at it compared to other similar types of businesses. For example, an average EBITDA/sales margin for the advertising industry is 17.39%, meaning that EBITDA is 17.39% of sales. This is a measure of profitability; a higher EBITDA/sales multiple than average means a company is more profitable.