This article will discuss EBITDA, how it’s calculated, and what it means for you as an investor.
Definition of EBITDA
EBITDA, which stands for “earnings before interest, taxes, depreciation, and amortization,” is a calculation to find the income from the operations of a business by separating this income from non-operations variables. To understand this metric, which can better reflect the operating profitability and financial health of a business, it’s important to take a closer look at each component of the acronym.
Business Earnings
Earnings is the same thing as net profit or net income of a business. It’s income minus expenses and includes earnings from all types of sources. Operating income is the income a business receives from its primary activities of selling products or providing services. This figure is shown on a business’s income statement (profit and loss statement) as “net income,” the income after gross profits (profits from operating activities).
The Variables of EBITDA
The four variables are usually shown in two sections on a financial statement—interest expense and taxes, then depreciation and amortization.
Interest: Interest expense is the cost of using money that was borrowed for business activities. It can be interest on a business loan or business investment. Taxes: Taxes for EBITDA are the taxes paid by businesses, including income taxes, excise taxes, and employment taxes (Social Security and Medicare taxes and unemployment taxes). Depreciation and Amortization: Depreciation and amortization are terms used to describe the process of deducting costs of buying and using long-term assets that a business uses to make a profit. A business deducts these costs over a period of time, depending on the type of asset. Depreciation is the deduction process used for tangible assets like vehicles, buildings, machinery, and equipment. Amortization is used to deduct the costs of intangible assets, those with no physical form, like copyrights, trademarks, and patents.
How Do You Calculate EBITDA?
Here is the formula for calculating EBITDA: EBITDA = Net Income + Interest Expense + Taxes + Depreciation + Amortization = Net Income from Operations. The table below outlines an example of EBITDA calculation. It answers the question, “Which company is best at generating income?” If investors are looking at several businesses of different types, they can rank them by their EBITDA to see which company is best able to turn sales into profits. EBITDA is one of several methods for analyzing profitability. A similar analysis is EBIT, earnings before interest and taxes.
Limitations of EBITDA
While EBITDA can be useful in determining profitability, there are still certain limitations in using the metric. For instance, EBITDA doesn’t reflect cash flow, which is another important measure for businesses. Cash flow is the inflow and outflow of cash to and from a business reported on a cash flow statement. EBITDA also isn’t included as a measure of net income as required for generally accepted accounting standards (GAAP). You may see “non-GAAP” on an EBITDA calculation, recognizing that this term doesn’t follow the standards.
Unusual chargesShare-based compensation for executivesLosses in paying off debtIncome or loss from discontinued operations (closing locations, for example)
These are special circumstances that may have a one-time or short-term effect on the earnings of the business. EBITDA margin is just one of many ways investors evaluate margin of safety.
EBITDA compared to salesEBITDA compared to sales, general, and administrative (SG&A) expensesEBITDA compared to research and development (R&D) expenses
To know if an EBITDA multiple is good, you must look at it compared to other similar types of businesses. For example, an average EBITDA/sales margin for the advertising industry is 17.39%, meaning that EBITDA is 17.39% of sales. This is a measure of profitability; a higher EBITDA/sales multiple than average means a company is more profitable.
