Why You Should Know What EBITDA Means and How to Use It
October 4, 2018
October 4, 2018
As a¬†small¬†business¬†owner, you may have been asked to calculate what is referred to as an¬†EBITDA¬†accounting report. The Term¬†EBITDA¬†is an¬†acronym¬†that stands for¬†Earnings before Interest, Taxes, Depreciation, and¬†Amortization.¬†EBITDA¬†is used as a measure to analyze and compare the¬†profitability¬†of¬†similar businesses¬†and industries without the effect of accounting and financing activities.
While¬†EBITDA¬†is widely used by investment professionals and lending institutions, it‚Äôs also a powerful tool for¬†business owners¬†to track and monitor¬†profitability, the operating health of their business, and their¬†company’s¬†financial performance.
The good news is that most online¬†small business¬†accounting software will perform an¬†EBITDA¬†calculation¬†for you.
So far we have talked about the importance of eliminating financial figures associated with management decisions in¬†EBITDA. Let‚Äôs now examine why eliminating these figures is critical.
Interest¬†on financing can significantly reduce the¬†gross¬†profit¬†of a company but does not indicate the vitality of a company‚Äôs operations.
Let‚Äôs say Company A and Company B are two identical companies in the same business. Company A has no debt and $1 million in gross revenue. Company B on the other hand has financed their entire operation at $1 million, and because of bad credit of the owner has a high-interest rate of 20%. But Company B has $1.25 million in gross revenue. All other things being equal, Company A would have a higher¬†gross¬†profit¬†than Company B. But Company B would have a higher¬†EBITDA.
So we see that based on discretionary management decisions, a company‚Äôs true potential or commercial viability can be altered or distorted, either intentionally or unintentionally.¬†EBITDA¬†aims to eliminate those distortions.
Several key groups look very carefully at a¬†company’s¬†EBITDA¬†number including investors, banks or other lending institutions, and acquiring companies. Investors and acquiring companies may use the number to assess the performance of the company against their peer group. They may also¬†use¬†EBITDA¬†figure to make non-related industry comparisons to help guide their investment decisions.
Lenders will generally look at¬†EBITDA¬†to assess management efficiency as well as the operational viability of a company. Since¬†EBITDA¬†limits the amount of ‚Äúfinancial engineering‚ÄĚ a company can do, it has become the top measure used to analyze the operational health of companies.
As a¬†business owner, the only way to improve your¬†EBITDA¬†is to drive revenue and grow your business. However, that is not to say that accounting strategies or financing are negative. It‚Äôs not. The overwhelming majority of companies use some type of financing and implement tax and accounting strategies to improve their¬†bottom line. These activities are productive and necessary to take advantage of tax rules and available financing.
The¬†EBITDA¬†margin¬†is a calculation that can be used by a¬†business owner¬†as a running score on the¬†operating¬†profitability¬†of the company as a percentage of its¬†total revenue. Once again, it is important to remember that¬†EBITDA¬†margin¬†is the truest¬†measure of a company’s health and vibrancy of just the business operations since it eliminates finance and accounting activities and focuses solely on your business activities.
The formula for¬†calculating¬†EBITDA¬†Margin¬†is as follows:
EBITDA¬†margin¬†= (earnings before interest and tax¬†+ depreciation +¬†amortization) /¬†total revenue
Some caveats to remember; although the¬†EBITDA¬†margin¬†is a good indicator of a company‚Äôs¬†financial health, it has a few drawbacks.¬†EBITDA¬†is not regulated by¬†generally accepted accounting principles¬†(GAAP),¬†so it is not normally calculated by companies that report their¬†financial statements¬†under¬†GAAP.
Eliminating accounting and finance decisions from a company‚Äôs financial records allows for the truest assessment of¬†profitability¬†by focusing on¬†net income. Since finance and accounting measures can be subjective, they can distort the¬†profitability¬†outlook of a company.
Within the ‚ÄúITDA‚ÄĚ elements of the measure (interest, taxes, depreciation, and¬†amortization) there is a lot of room for financial engineering that can significantly alter the appearance of the¬†financial health¬†of a company. Executives and¬†business owners¬†can use these accounting tools to create specific results that are not reflective of the core business operations.
To understand¬†EBITDA¬†fully we should take note that this is a measure that aims to eliminate the effects of management decisions like financing (cost of capital) and tax strategies implemented by the company. Since different companies and different industries have varied financing and accounting structures,¬†EBITDA¬†works to equalize or level these differences and conditionally create a ‚Äúlevel playing field‚ÄĚ.
EBITDA¬†is often confused with¬†gross¬†profit.¬†EBITDA¬†differs from¬†gross¬†profit¬†because¬†gross¬†profit¬†is calculated by taking the difference between Gross Revenue and subtracting the¬†cost of goods sold¬†(COGS). COGS will include labor, taxes, etc. (nonoperational expenses). COGS includes items affected by management decisions. To get to your¬†EBITDA¬†figure you would take¬†Gross¬†Profit¬†and subtract the nonoperating expenses from that number.