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How EBITDA Works: How To Calculate And Use EBITDA

how-ebitda-works:-how-to-calculate-and-use-ebitda
How EBITDA Works: How To Calculate And Use EBITDA

Picture this scenario: A manufacturing company reports little profit due to large expenses that reflect the wear and tear on factories and machinery, as well as interest costs on borrowed money. This may not be appealing to potential investors at first glance, so executives decide to present a more favorable measure of financial performance known as EBITDA, which ignores many of these expenses.

Here’s what you need to know about EBITDA, plus how businesses use it alongside standard measures of profitability.

What is EBITDA?

EBITDA is an acronym for earnings before interest, taxes, depreciation, and amortization. It is typically used by companies with large capital expenses, such as manufacturers, and by early stage technology companies that are not yet profitable and spending heavily on research and development. 

EBITDA became popular in the 1980s, when acquired companies with heavy debt financing—a process known as a leveraged buyout— were evaluated based on their ability to service the debt in the short term. Thus, amortization and depreciation were not deemed immediately relevant. Interest and taxes are also excluded since those undergo changes during acquisition and modify the company’s capital structure.

EBITDA is sometimes useful because it shows a company’s ability to generate cash earnings by excluding many non-cash expenses from its income statement. EBITDA also excludes interest and taxes because interest costs depend on how much a company borrows, and taxes can vary depending on a company’s location and tax rates. These exclusions mean EBITDA is higher than net income—or even positive when a company has net losses.

How to calculate EBITDA

The most common way to calculate EBITDA starts with earnings, or net income. From there, expenses for interest, taxes, depreciation, and amortization are added back. The EBITDA formula therefore is:

Earnings + interest + taxes + depreciation + amortization = EBITDA

The challenge in determining EBITDA is finding the depreciation and amortization amounts, as well as interest and income taxes. This might require searching in places beyond the main income statement, such as supplements and management notes. Depreciation and amortization often can be found in a company’s cash flow statement, specifically the cash flow from operations.

EBITDA components

EBITDA contains the following components:

Earnings

This is the bottom line, or net income, on an income statement after all cash and non-cash expenses are subtracted. EBITDA calculations usually start here, although you could also start with operating income or earnings before interest and taxes (EBIT). In that case, only depreciation and amortization must be added back.

Interest

Interest expense on debt is listed before taxes because the cost is tax-deductible, lowering a company’s taxable income. For example, if Company A and Company B both have operating income of $20 million, but Company A paid $5 million in interest, its taxable income is $15 million, while debt-free Company B’s taxable income is $20 million, because it has no interest expense to deduct.

Taxes

A company’s income tax expense is based on its taxable income and its percentage tax rate. Income tax is typically the next-to-last line on the income statement before net income. Property taxes are included in operating expenses. Capital gains taxes appear below operating income and are taxed at different rates, depending on how long a capital asset was owned. Per the above example, assuming both companies are taxed at 20%, Company A pays $3 million in taxes and Company B pays $4 million. For purposes of EBITDA calculations, Company A adds back a combined $8 million from interest and taxes while Company B adds back only $4 million from taxes.

Depreciation

Depreciation is a non-cash expense that represents the estimated decline in productive value of a company’s tangible assets, such as property, plants, and equipment. Imagine a manufacturer that buys new machinery for $50 million with an estimated useful life of five years. To account for the wear and tear on the assets, the company records a $10 million non-cash expense in each of the next five years to represent the declining value, even though it paid upfront for the machinery. 

Amortization

Amortization, like depreciation, is a non-cash expense. It accounts for the estimated reduction in value of intangible assets, such as software development and intellectual property, including patents, trademarks, and copyrights. Unlike depreciation, which can vary based on assumptions about an asset’s useful life and how much to depreciate each year, amortization typically follows a set schedule, such as 15 years in equal annual expense.

Importance of EBITDA

Using EBITDA can be beneficial to business managers and financial professionals in several ways, including: 

It helps you focus on operations

Setting aside the non-operating expenses of interest and taxes, as well as the non-cash items of depreciation and amortization, makes it possible to analyze a company on the strength of its core operations and ability to generate cash. EBITDA is sometimes referred to as a normalized measure of performance.

It allows you to make comparisons

Removing non-cash expenses, which can differ dramatically from company to company, makes it easier to compare different companies and their ability to generate EBITDA as a share of revenue (a measure that’s similar to profit margins).

It’s capital-structure neutral

EBITDA removes any bias about a company’s choice of debt or equity to fund operations, again showing how a company’s underlying operations perform.

It lets you assess debt service ratios

EBITDA can provide a clearer picture of a company's ability to pay interest on debt, using ratios such as EBITDA-to-interest-expense. For example, if a company has annual EBITDA of $20 million and interest expense of $2 million, its debt-service coverage ratio is 20-to-2, or 10. Higher is better for this ratio.

It’s useful for valuation

In determining a company’s value for possible sale to investors or another company, EBITDA is a key metric. A common measure is enterprise-value-to-EBITDA. A company’s enterprise value is the total market value of its shares, plus its debt. So, for example, if a company has an EBITDA of $20 million and similar companies have been sold at prices representing 10 times EBITDA, then the company might be valued at about $200 million.

Limitations of EBITDA

EBITDA may not always be the best way to assess a company’s financial performance. Among EBITDA’s limitations:

It ignores interest and taxes

These are real cash costs that represent money going out the door, and they reduce a company’s profit.

It neglects asset deterioration

One of the biggest criticisms of EBITDA is that it pretends that assets don’t decline in value. Some leading investors, including Warren Buffett, chairman of Berkshire Hathaway Inc., have said depreciation and amortization represent real costs that are properly reflected in the income statement. Neither does it account for capital expenditure necessary to repair or replace worn-out assets.

It overstates profitability

Because EBITDA is greater than net income by excluding various expenses, the market valuation of a company may seem inflated. EBITDA can make a company look more profitable than it really is; in many cases, companies with positive EBITDA report losses on the income statement.

It’s not GAAP-approved

EBITDA is an improvised measure, not approved under generally accepted accounting principles (GAAP). Net income is approved because it uses accrual accounting to match income with associated expenses over time. Companies may present EBITDA to investors in conjunction with net income, but not as a substitute.

EBITDA FAQ

What is the difference between EBITDA and EBIT?

EBITDA excludes four expenses from earnings—interest and taxes—which are cash expenses, and depreciation and amortization, which are non-cash expenses. EBIT, which is the same as operating income, excludes interest and taxes; depreciation and amortization have already been deducted as part of operating expenses.

Why is EBITDA misleading?

EBITDA is sometimes misleading because it excludes significant and important expenses that reflect the true costs of operating a business. EBITDA should be evaluated along with net income and other metrics of business performance.

What is a good EBITDA?

Managers and analysts usually evaluate EBITDA in terms of margins, such as a percentage of revenue (this is similar to profit margin). A good EBITDA may depend on a company’s past performance or be relative to its competitors or a market benchmark. In 2023, the average EBITDA margin for the S&P 500 Index, for example, was almost 24%, more than double the average net income margin.

When should you use EBITDA?

Manufacturers with large, depreciating assets will often use EBITDA to compare themselves against other manufacturers and against their own net income. Young technology companies with big startup costs for software development, which may be depreciated or amortized, also will often cite EBITDA when they have minimal earnings or losses.

What are the components of EBITDA?

The components for calculating EBITDA are earnings, or net income, minus the following: interest paid on any debt; income tax paid; depreciation of the value of tangible assets; and amortization of the value of intangible assets.

This originally appeared on Shopify and is available here for wider discovery.
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