EBITDA is one way to evaluate a company’s earnings without the influence of financial variables like interest on loans, government taxes, depreciation expenses on tangible assets and amortized expenses on intangible assets.
It is one way to create a level playing field when comparing company earnings in similar industries but it is not without controversy as some feel it does more harm than good.
As a small business owner looking to sell your business, or a future small business owner looking to purchase a small business, you have probably seen references to a company’s EBITDA or EBIT. You may even have a high-level understanding of what it is and how it is calculated. But what does it really mean and is it a good indication of the success of the business? And as a small business owner, should you care?
Some financial experts believe that it is a crucial measurement of a business’s potential success where others believe it can be misleading at best. Both views have merit. Regardless of its pros and cons, all would agree that EBITDA should never be a single measurement when evaluating a business of any size.
Regardless, both EBIT and EBITDA are fairly easy to calculate if you have access to the company’s financial statement.
This article will take a look at this contentious metric called EBITDA and why you should at least be familiar with how it can be used effectively. We will take a look at the formula for calculating EBITDA and how you can use it to evaluate similar businesses. However, we will also discuss the drawbacks to EBITDA especially if it is your primary yardstick for continued success.
What Exactly Is EBITDA… simplified
EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization.
It is a way to measure profitability for the comparison of one company to another in a similar industry. In some cases, EBITDA can provide a more accurate representation of the company’s overall performance when measured over time.
Question: Before we get into formulas, you may be curious why you would want to calculate EBITDA if it strips out items such as interest on loans, taxes to be paid, depreciation and/or amortization of assets? These seem like fairly important expenses you would want to take into consideration when evaluating the financial status of any business.
Answer: EBITDA can be a measure of how well a company is doing by removing the impacts of accounting and financial deductions. Some believe it to be a more accurate representation of the company’s real earnings. Debt interest, taxes owed and the management of depreciation and amortization are accounting functions that in theory can change with new owners.
By removing the impact of these functions from the equation, you can analyze different companies with a comparison metric.
Another benefit is that it more clearly indicates how much cash flow a company has on hand to reinvest in the business or pay dividends. It also is seen as an indicator of the efficiency of a company’s operations.
EBITDA is a way to tell if a company is profitable. It shows the amount of money they make from their normal business operations.
Simply put, it places focus on earnings while removing some business factors that may not be within the company’s control from consideration.
You can’t say EBITDA without EBIT…
EBIT is Earnings Before Interest and Taxes.
A small business owner will typically find EBIT to be attractive for their small business evaluation because it removes the impact of these two deductions that are not within a company’s control.
Basically, how much money were you making before you paid out to the government (taxes) and to your lenders (interest)?
While there are 2 ways to calculate EBIT, the most common is…
EBIT = Net Income + Interest + Taxes
Take your Net Income and add the Interest and Taxes back in. Doing so removes the impact of these items from the company’s ability to generate earnings from operations.
We want to overlook interest and taxes from time to time because it allows us to examine a company’s capacity to create revenues or profits from operations. By focusing on operational profitability, we can more clearly assess the company’s operations and identify prospective growth, as well as the company’s capacity to pay off debt.
There is another way to calculate EBIT which is less popular, but you should be aware that it exists.
EBIT = Revenue – Cost of Goods Sold – Operating Expenses
Both methods, in theory, should give you the same number.
Here is a quick example to better demonstrate how EBIT is calculated…
You are interested in purchasing the fictional company “SignCo” which produces and sells signage in your city. All of this information should be made available on SignCo’s financial statement:
|Cost of Goods Sold (CoGS):||$700,000|
|Net Income +||Interest +||Taxes =||EBIT|
|$464,000 +||$70,000 +||$40,000 =||$574,000|
Remember, by adding Interest and Taxes back into Net Income, you now have a metric to measure the cash flow a business has to reinvest into the company or pay dividends.
But what about things like depreciation and amortized assets?
If we include those as well, we have the more common reported metric, EBITDA.
EBITDA vs EBIT
Now that we understand EBIT, we can go further and make considerations for Depreciation and Amortization expenses along with Interest and Taxes.
The logical formula for EBITDA is…
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
EBITDA is often used to compare and assess profitability across multiple companies since it excludes the impacts of not only financial expenditures but capital ones as well.
When the cost of long-term assets are split and recorded as an expense over time, a depreciation expense is produced. Companies in many sectors will have a large amount of equipment on the books which will naturally produce a high depreciation expenditure.
While depreciation is tied to tangible assets, amortization is tied to intangible assets to be paid back over time. For example, franchise agreements, organizational cost, intellectual property and patents.
When you add back the depreciation and amortization expenses to EBIT, you can further compare the earnings between companies without those financial components.
It’s not as complicated as it sounds.
Let’s use the same scenario as above and now calculate the EBITDA.
We are still interested in purchasing the fictional company “SignCo”. According to the income statement, there is…
|Cost of Goods Sold (CoGS):||$700,000|
|Net Income +||Interest +||Taxes +||Depreciation +||Amortization =||EBITDA|
Using the EBITDA measurement, the owners of SignCo are stating to have $600,000 in operating profit but note, this not only excludes loan interest and taxes but also depreciation and amortization expenses.
If you were evaluating multiple companies in the same sector, this would allow you to make closer comparisons.
While EBIT and EBITDA are interesting measurements, they are a snapshot of a number in time. On their own, they are not a good indicator of small business success because they do not include depreciation or amortization expenses. You should be looking at multiple indicators to evaluate small businesses (i.e.: Sales, Net Income, Total Assets, Cash Flow). Ideally, you would look at EBITDA over time and determine if the number is trending up or down.
EBITDA vs Cash Flow
As a business owner or future business owner, you understand that a healthy cash flow is one of the more important measures of a small business’s ability to be successful.
While there is a valid use for EBITDA, it certainly is not cash flow and should not be confused as such. It can be, however, a “proxy” for cash flow.
What does this mean?
EBITDA is a better measure of profitability for small businesses because it takes into account all the factors that can skew and affect cash flow like depreciation, amortization, interest rates on loans or credit cards, etc.
In other words, while EBITDA does not represent the actual cash in your bank it does represent the amount of cash you would have if all the factors that can affect it like depreciation were removed.
Net Cash Flow, on the other hand, is the amount of money owners can put into their pockets after expenses.
Imagine Net Cash Flow as the amount of income that can be removed from the business without affecting profits. For potential buyers, they need to know that the cash flow can provide service to cover all costs of running the business.
Quick EBITDA FAQ
How is EBITDA calculated?
EBITDA is calculated fairly easily using numbers that are readily found on a company’s income statement and balance sheet.
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
What is EBITDA?
EBITDA, or earnings before interest, taxes, depreciation, and amortization, is a financial performance indicator that can be used in place of net income in some cases.
What are the warning signs for investors when it comes to EBITDA reporting?
Companies often stress EBITDA over net income because it is more flexible and in some cases, draw attention away from other issues in the financial statements. When a business begins to disclose EBITDA prominently after not doing so in the past, investors need to take warning and dig deeper into the company performance.
What is an EBITDA Margin?
An EBITDA margin is a measure of how a company’s profits are doing, found by dividing the company’s earnings before interest, taxes, depreciation and amortization with its revenue. Investors use this number to know how efficiently the company operates or it’s financial health.
The EBITDA margin formula is: EBITDA / total revenue
What are the benefits of EBITDA margins?
This percentage tells you how much of a company’s expenses are being consumed by its profits. The higher the percentage, the better off the company is and the lower the risk it carries.
Is EBITDA the best way to determine how successful a business is or will be?
No. Investors should look at net income, cash flow metrics, and financial strength to understand the company’s financial health.
What are the pros and cons of using EBITDA?
Supporters of the EBITDA formula claim that it offers a more accurate picture of how well a firm is operating, while opponents argue that it may be used to conceal warning flags such as excessive levels of debt, rising expenditures or simply, lack of profitability.
What is the difference between healthy and unhealthy EBITDA?
EBITDA that is reviewed over a prolonged period of time and remains positive or trending upwards can be viewed as a business having a healthy EBITDA.
What is LTM (Last Twelve Months)?
LTM (Last Twelve Months) EBITDA, also known as Trailing Twelve Months (TTM), is a valuation statistic that indicates your profits before interest, taxes, depreciation, and amortization for the previous 12 months.
Small-business owners should have a comprehensive grasp of how prospective buyers or investors would assess the worth of their company as a crucial component in a successful sale. Company value is often a multiple of the company’s earnings.
It is, however, critical to recognize EBITDA’s limits. Although it is frequently used as a proxy for assessing a company’s earning potential, EBITDA cannot quantify cash flow since it excludes the cash necessary to support working capital and equipment improvements. This is one of the greatest criticisms of the EBITDA metric.
As a result, current and future owners of small businesses should consider EBITDA alongside other critical elements such as capital expenditures, changes in working capital requirements, debt payments, and net income.
When it comes time to sell your business and you upload your business details on Otonomy.ca, it is up to you if you want to include your EBITDA. Buyers may ask for it but ultimately it is up to both parties to perform their due diligence before buying or selling their small business.