what is ebitda

Is your business healthy and profitable?

As a small business owner or entrepreneur, it’s a question you have to answer regularly.

In fact, the top seven times you must know the value of your business are when you:

  • Need to figure out if it’s heading in the right direction
  • Want to know how it compares to competitors
  • Hope to attract private equity and other investors
  • Apply for a loan or other types of financing
  • Want to get listed on a stock exchange
  • Prepare to sell your business
  • Pass your business on to your heirs.

The best way to fully understand the value of your business and clearly communicate it to others is through EBITDA. It’s a more complete way to do so than merely focusing on net income, revenue, or cash flow. It allows you to compare the health of your business with that of others.

I’ll explain everything you need to know about EBITDA so you can accurately use it to calculate the value of your operation in this article. I’ll also go into greater depth about the seven times you must know the value of your business through an EBITDA calculation.

  • What is EBITDA?
  • How often do businesses calculate EBITDA?
  • What’s the difference between EBIT and EBITDA?
  • Are there other types of EBITDA calculations?
  • How do I calculate EBITDA?
  • How do I know if my EBITDA valuation is good?
  • Why is it important to calculate EBITDA?
  • What can I do to improve the EBITDA of my business?
  • How do I recast EBITDA value?
  • What are the pros and cons of EBITDA?
  • When do I need to know the EBITDA of my business?

What is EBITDA?

Let’s start with the basics.

EBITDA stands for earnings before interest, taxes, depreciation, and amortization.

EBITDA measures the overall financial performance of businesses. EBITDA is an alternative to other measurements, including earnings, revenue, and income.

The terms that make up the acronym EBITDA each have their own meaning and reason for being part of the EBITDA calculation.

  • Interest: Any expenses impacted by interest rates, such as interest on all types of loans
  • Taxes: All federal, state, local, and income taxes a business is responsible for paying
  • Depreciation: The reduction in the value of fixed company assets
  • Amortization: The write-off of the cost of intangible assets.

Interest and taxes are cash expenses. Depreciation and amortization are non-cash expenses.

EBITDA reflects the financial success of operating decisions made by an organization and its leadership by eliminating the impact of non-operating factors, including tax rates, interest expenses, and significant intangible assets. It provides a precise measurement that reflects the operating profitability of a business. You and other interested parties can compare your company’s EBITDA with the EBITDA calculations of other companies. The ability to compare multiple EBITDAs is valuable to business owners, investors, stakeholders, and potential buyers.

Interesting fact: The ability to compare business results related to its leaders’ operational decisions is why EBITDA is often preferred over other metrics when comparing businesses as part of a mergers and acquisition effort. It shows which company is healthier and better managed.

How often do businesses calculate EBITDA?

Companies can calculate EBITDA for any business accounting period, monthly, quarterly, or annually. An annual calculation, known as LTM (Last Twelve Month) EBITDA is most common for small businesses. It provides a valuation metric representing all earnings before adjustments associated with interest, tax, depreciation, and amortization over the past 12 months. It’s a valuable piece of data that can help company leadership understand whether the business decisions they made over the last year were good ones.

Did you know: LTM EBITDA is also known as TTM (Trailing Twelve Months) EBITDA?

What’s the difference between EBIT and EBITDA?

EBIT is a variation on EBITDA. It’s simpler to calculate but not as complete as EBITDA.

EBIT stands for Earnings Before Interest and Tax. It represents the value of earnings, including taxes and interest’s impact on it. EBITDA goes further by identifying and removing depreciation and amortization expenses. Both EBIT and EBITDA are good ways to understand a company’s value by documenting and considering different expenses and their impact on the value of a business.

Are there other types of EBITDA calculations?

In addition to EBIT, there are several other variations of EBITDA, including:

  • EBIAT — Earnings before interest after tax
  • EBIDA — Earnings before interest, depreciation, and amortization
  • EBITDAR — Earnings before interest, tax, depreciation, amortization, and restructuring/rent costs
  • EBITAC — Earnings before interest, taxes, depreciation, amortization, and coronavirus.

All of these represent different ways to view a company’s worth. Potential buyers, investors, and financial firms (including loan companies) use EBITDA and its variations to compare the valuation of different businesses and determine their financial soundness. Business owners can benefit from an EBITDA calculation by using it to help guide their operational decisions to improve their company’s profitability. It’s also valuable information to have if they’re thinking of selling their business.

Accountants and other experts often compare EBITDA with Seller’s Discretionary Earnings (SDE), which is used to figure out a business’s historical cash flow. An SDE calculation starts with net profit and then adds in the owner’s salary and non-cash profits. SDE is similar to EBITDA. The big difference is that larger companies express their value as EBITDA and smaller ones use SDE.

Check out other ways to calculate the value of your business.

How do I calculate EBITDA?

Accountants use one of two formulas to calculate EBITDA:

  • EBITDA = net profit + interest + taxes + depreciation + amortization
  • EBITDA = operating income + depreciation + amortization

All the information you need for an EBITDA calculation should be in your company’s income statement.

Important note:  An EBITDA calculation must be 100 percent accurate. If it’s not, it could contribute to bad business decisions, misinformation, and misrepresenting the company to potential investors and buyers. It’s a good idea to use a professional accountant to calculate your EBITDA.

Check out Biz2Credit’s EBITDA calculator.

How do I know if my EBITDA valuation is good?

Calculating EBITDA is just the beginning. The next step is to figure out whether the EBITDA you have calculated represents a well-managed and profitable business or not. Here are some ways you can figure that out.

EBITDA margin

The EBITDA margin is the percentage that results from dividing EBITDA by the company’s total revenue. As a formula, it’s:

  • EBITDA margin = EBITDA / total revenue

It will help you determine the cash profit your company makes in a year. If the EBITDA margin of your business is greater than the EBITDA margin of other businesses, it indicates that your’s has greater growth potential. If it’s lower, it could be a sign of trouble.

Here’s an example of an EBITDA margin evaluation:

  • Company A has an EBITDA of $650,000 and total annual revenue of $7,000,000. The EBITDA margin is 9.3 percent.
  • Company B has an EBITDA of $600,000 and total annual revenue of $6,000,000. The EBITDA margin is 10 percent.

Company A may have a higher EBITDA, but Company B has a higher EBITDA margin. That means Company B has greater growth potential, making it more attractive to investors and prospective buyers.

EBITDA coverage ratio

Many consider the EBITDA coverage ratio as a solvency ratio. It measures the ability of a business to pay off its lease and debt liabilities using EBITDA.

You can come up with your EBITDA coverage ratio by dividing the total of your lease payments and EBITDA by the sum of principal and interest (debt) payments and lease payments. The formula for this is:

  • EBITDA coverage ratio: (EBITDA + lease payments) / (interest payments + principal payments + lease payments)

When your EBITDA coverage ratio is greater than one, it shows your business can pay off its liabilities, debts, and other obligations. That makes it an attractive option for investors and potential buyers. If it’s below one, it’s time to rethink your business finances.

Unlike the EBITDA margin, which involves comparing two or more companies, the EBITDA coverage ratio represents a single company’s ability to pay off debt.

EBITDA multiple

An EBITDA multiple is a ratio that compares your annual EBITDA with your company’s overall enterprise value (EV). Business owners use the EBITDA multiple to calculate their company’s value and compare it with similar businesses. The formula for it is:

  • EBITDA multiple = enterprise value / EBITDA

You calculate enterprise value by adding together the value of your debt, minority interest, market capitalization, and preferred shares. Then, subtract cash you have on hand and cash equivalents, including marketable securities, bank accounts, and treasury bills.

The formula for calculating enterprise value is:

  • Enterprise value = (market capitalization + value of debt + minority interest + preferred shares) – (cash and cash equivalents)

The EBITDA multiple ratio will show you if your company’s value is under or overstated. A high ratio shows that the worth might be overstated, while a low one may indicate its undervalued.

One benefit of using the EBITDA multiple is that it considers company debt, which things like price to earnings ratio (more commonly referred to as P/E ratio) do not.

Calculating enterprise value, net income, and EBITDA

EBITDA represents a company’s ability to make a consistent profit, while net income represents a company’s total earnings. Net income is usually used to identify the value of earnings for every share of a business. You can use it with the formula:

  • Net income = revenue – business expense

Operating income and EBITDA

Experts define operating income as business profit after removing operating expenses, including amortization and depreciation. It represents the ongoing cost of running your business. Use the following formula to calculate it:

  • Operating income = revenue – the cost of goods sold – operating expenses

Business owners and others typically use operating income to analyze the production efficiency of a company’s operations.

EBITDA takes operating income to the next step by further stripping these expenses, focusing exclusively on your business’s profitability.

In the end, both operating income and EBITDA are essential calculations that can determine the value of a business.

Adjusted EBITDA

The differences between EBITDA and adjusted EBITDA are minor. However, it’s essential to understand them. Adjusted EBITDA normalizes the calculation based on a company’s revenue and expenses. Revenue and expenses can differ significantly among companies, making it challenging for financial analysts and buyers to determine whether one is more attractive than another.

By standardizing cash flows and income by removing any unusual items, including things like owner bonuses, duplicative assets, and rent paid above market value, adjusted EBITDA allows people to analyze multiple businesses at once based on comparable data. In other words, it’s a precise apples-to-apples comparison.

Accountants can use either of the EBITDA formulas to calculate adjusted EBITDA. However, before doing so, they remove any unique, irregular, and one-time expenses that have no impact on regular business operations.

Some standard EBITDA adjustments include:

  • Non-operating income
  • Non-cash expenses
  • Unrealized loss or gain
  • Single-time loss or gain
  • Litigation expense
  • Donations and goodwill impairments
  • Above market compensation for the owner
  • Asset write-downs
  • Gain or loss in foreign exchange.

Why is it important to calculate EBITDA?

Regularly calculating and evaluating EBITDA is important for five reasons:

  • It provides critical information about your company’s value.
  • It helps you track whether your business is becoming more or less valuable over time, which indicates how well you and your management team are doing.
  • You’re always ready to demonstrate to investors the value of your business and its growth potential.
  • It can be a good indication of your company’s value and growth potential when you apply for loans and other types of financing.
  • It may even help you identify potential cash flow issues before they happen.

What can I do to improve the EBITDA of my business?

Business owners usually include EBITDA and other statistics for at least three to five years when they want to sell their business. The numbers should show that the company has grown over time and that future growth is likely.

As I’ve already covered, higher EBITDA indicates better business performance.

If your EBITDA isn’t what you want it to be, recast your company financials.

How do I recast EBITDA value?

Recasting is the process of amending or re-releasing earning statements for a specific reason. Typically, accountants will review business financial statements and add back any one-off expenses or earnings on the balance sheet. Ideally, this process will result in a more favorable financial picture.

Be aware: Recasting isn’t the same as “fudging the numbers” to mislead prospective buyers. The factors included in the recasting are transparent, and auditors can identify them during the due diligence process.

Some things that can be recast include:

  • Expenses or revenue from non-essential assets
  • One-time fees
  • Owner’s salary and bonuses
  • Repair and maintenance expenses
  • Non-arms-length expenses and revenue

Your accountant can advise you if these adjustments make sense if you ever need to recast your EBITDA.

What are the pros and cons of EBITDA?

Like most things, there are good and bad things about EBITDA calculations.

<h`3 style=”margin-bottom:10px;”>Pros of EBITDA

  • EBITDA is used almost everywhere and is universally understood.
  • EBITDA removes unique company variables to allow more equalized apples-to-apples business valuation comparisons.
  • EBITDA is relatively simple to calculate and evaluate.
  • EBITDA is a reliable business valuation metric that makes it easy for interested parties to focus on a company’s profitability.

<h`3 style=”margin-bottom:10px;”>Cons of EBITDA

  • Because EBITDA focuses on baseline profitability by eliminating capital expenditures, it might hide important information about improper or out-of-control expenses.
  • GAAP (Generally Accepted Accounting Principles) does not recognize EBITDA, which means companies are free to use it as they see fit, which can gloss over significant business issues.

Consult with your accountant or other financial professionals to determine how you can effectively use EBITDA calculations in your business.

When do I need to know the EBITDA of my business?

The top seven times you must know the EBITDA of your business are when you:

  • Need to figure out if it’s heading in the right direction. EBITDA is a defined and consistent benchmark that you can track from year to year, quarter to quarter, or month to month that will show your business’s valuation is going up. It’s a clear sign you and your team are making good operational choices and things are heading in the right direction.
  • Want to figure out how it compares to competitors. EBITDA is universal. It makes it possible to compare your company valuation, and various aspects of its performance, to other companies in your industry.
  • Hope to attract private equity and other investors. Investors will want to know that your business is healthy and positioned for growth. They’ll also want to compare your company to other investment options. In its various forms, EBITDA will provide them with all the information they need.
  • Apply for a loan or other types of financing. Some lenders will request EBITDA calculations and other data that shows you’re a good loan prospect who will pay their money back.
  • Want to get listed on a stock exchange. EBITDA is a data point that can help prove that it’s worthy of being publicly traded.
  • Sell your business. EBITDA will help prove to potential new owners that your business is sound, growing, and has solid potential to continue to grow in the future. It’s also a recognized way for buyers to compare different purchase options using identical — or extremely similar — data.
  • Pass your business on to your heirs. When you leave your business to someone else after you pass away, having a current EBITDA calculation as a part of your will help them quickly understand the state of the operation and whether they want to keep or sell it.

If you ever find yourself involved in these situations, a good starting point is to meet with your accountant. They can help you calculate your EBITDA and explain its value in different situations.

Learn more about EBITDA.

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