June 26, 2019 | Last Updated on: July 10, 2024
What is EBITDA? We’ll Show You How to Calculate EBITDA for Your Business
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a measure of financial performance, and it is an important part of the financial analysis of a company. We’ll cover the basic concepts on how to calculate EBITDA for a small business.
Private equity investors, business owners, and buyers of small businesses all use EBITDA because it reflects a close estimation of the real cash flow that is available to invest in the business, pay interest on debt, and provide returns for shareholders. In order to get EBITDA, you add back several expenses that are considered – whether rightly or wrongly – to be one-time or inconsequential. For this reason, EBITDA not a complete picture, because interest and taxes aren’t optional cash expenses. However, EBITDA is still a useful measure of a business’s ability to generate real cash profits. EBITDA is especially important in restructuring scenarios, in which a company takes on debt because investors need to make sure that a company has enough cash flow to pay the interest on its debt so that it doesn’t fall into credit default. Financial analysts sometimes use EBITDA and the EBITDA margin (EBITDA / Total Revenue) to better understand a company’s financial performance. For example, if a company’s EBITDA margin is 35%, that means the company was able to make a 35% cash profit off its total revenue for the time period.
Different companies have different tax rates and capital structures that result in different ways of calculating net income. Since EBITDA eliminates several variables that vary between companies, including taxes, depreciation, interest, and amortization expenses, it can provide you with a more objective view of a company’s performance against competitors. If you are ever looking to sell your company, many business buyers will use a multiple of EBITDA as one component to determine the business valuation. For example, if a company’s EBITDA is $1 million and a buyer is worth paying a 7X multiple, then that buyer will pay $7 million for the business. If you have an estimate of the value of a business – also known as the Enterprise Value – based on a forecast or what it has recently sold for, you can determine the multiple by dividing the Enterprise Value by the EBITDA. Business buyers will typically hunt for companies that will sell for lower multiples because they represent a “better deal.”
Beware – EBITDA is not a regulated financial measure or term, and it has some downsides. One thing that is important to know is that EBITDA is not regulated by generally accepted accounting principles (GAAP) and there are ways that companies can manipulate their EBITDA to make it look better or worse. In addition, EBITDA can provide a distorted picture of a company’s value if the company has a high level of debt or high capital expenditures (like really expensive equipment). Since EBITDA adds back interest payments, it can create the illusion that a company has more cash flow than it actually does, which can lead a company to take on more debt than it should. In addition, EBITDA adds back amortization and depreciation, but in reality those two figures can’t be postponed forever, and assets like equipment will need maintenance and replacement. Finally, companies with low net income can sometimes have high EBITDA, so look closely at all financial statements to make sure you have a complete picture of a company’s financial health.
How you calculate EBITDA can’t be found on an income statement, but it can be calculated in one of two ways. Either you use Method 1 below and take the firm’s operating income and add back non-cash depreciation and amortization expenses. Or you can work backwards and use Method 2 below by taking the net income and adding back the following line items: interest, taxes, depreciation, and amortization.
Step 1: Find Operating Profit (EBIT) on your income statement Step 2: Plus (add back) depreciation expense from the cash flow statement Step 3: Plus (add back) amortization expense from the cash flow statement Step 4: The result will be EBITDA
EBITDA = EBIT + Depreciation + Amortization
Step 1. Find your company’s net income (sometimes called “net profit”) Step 2. Plus (add back) interest expense Step 3. Plus (add back) taxes Note that: the taxes you typically add back are federal and state income taxes. You don’t add back all taxes. For example, you don’t add back sales taxes or payroll taxes because they are part of operating expenses and will be paid no matter what your company’s capital structure is. Step 4. Plus (add back) depreciation expense from the cash flow statement Step 5. Plus (add back) amortization expense from the cash flow statement Step 6: The result will be EBITDA
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization Use The Biz2Credit EBITDA Calculator
An “add back” is an expense that you add back to a profits measure in order to get a more nuanced understanding of a company’s profits and cash flows.
Tip #1: Do Not Only Use EBITDA EBITDA does not provide a complete picture of your company’s financial performance, profitability, or cash flow. It can be one useful measure, but should not be used in isolation. Provide your investors and partners with multiple metrics of your company’s financial performance so that they can understand the full picture. Tip #2: Use EBITDA Responsibly Do not manipulate your EBITDA numbers in order to appear more profitable than you are. In that same vein, if you are looking at a company’s EBITDA numbers, examine all of their financial statements closely and do not use their EBITDA number by itself to gauge the company’s viability. Companies have a great deal of discretion in how they describe their EBITDA, and it is important to peek behind the curtain.
