EBITDA is a measure of a company's operating performance before accounting for interest, taxes, depreciation and amortisation. The rationale behind using EBITDA is to provide a clearer picture of a company's operating profitability by excluding non-operating expenses and accounting practices.
“EBITDA can support a business owner in assessing how efficiently they are generating earnings from their core business operations,” says Alan Hamilton, a Partner in corporate finance at accountancy firm Johnston Carmichael. “Management can use EBITDA to assess the company’s overall operational efficiency and to understand what cashflow the business has available to support decisions, such as investment and expansion, or taking on new debt.”
Calculating EBITDA, each element explained
EBITDA is easily calculated using figures found on your income statement. To calculate EBITDA, take net income, then add interest, tax, depreciation and amortisation. Here’s a closer look at the EBITDA formula, what each component means and where to find it.
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortisation
Net income
Net income, also known as net profit, is the total amount of money your business makes from selling its products or services, minus expenses, including operating expenses. It is often referred to as the bottom line, as it sits at the bottom of the income statement and is the money that remains after all expenses, debts and costs have been deducted from revenue.
Interest
This is the interest your business owes on credit, loans and other debt.
Taxes
These vary and depend on where your business operates. In the UK, it can include corporation tax, value-added tax (VAT) and national insurance.
Depreciation
Depreciation reflects the loss in value of any tangible assets your business may have during the accounting period. For example, buildings, vehicles and equipment that lose value over time due to wear and tear.
Amortisation
Amortisation considers the loss in value of intangible assets, such as patents and trademarks. Similar to depreciation, the figure represents an incremental loss in value of the asset over its expected lifetime.
Why EBITDA matters on the income statement
A company's income statement is one of the main financial documents a company is legally required to produce each year. Also known as a profit and loss statement (P&L), it provides a high-level view of how the company has performed over the past 12 months. Below is an example of a small business's income statement, and how EBITDA might be shown on it:
EBITDA reflects the company's cash generation from sales of goods or services. This includes expenses such as costs of goods sold (COGS) and overhead costs, the latter being recorded on the income statement as "selling, general and administrative" expenses.
By excluding expenses such as debt interest and taxes that are unrelated to operations or performance, EBITDA offers a clearer picture of a company's financial health for owners and potential investors. Taxes, for example, may change based on location, period or new legislation.
“By removing the impact of non-operational costs, such as tax and financing costs, EBITDA represents the cash flow generated by ongoing business operations,” says Hamilton. “It provides an excellent overview of how a business is performing.” For this reason, it is often used to value a company and compare it to competitors or industry averages.
EBITDA vs operating profit
The main difference between EBITDA and operating profit is the inclusion or exclusion of depreciation and amortisation. EBITDA excludes depreciation and amortisation costs, whereas operating profit includes them. You can find the operating profit on your income statement, and it is typically lower than EBITDA, given it takes into account depreciation and amortisation.
"The ITDA in EBITDA are such long-term components of bottom line profit, there isn’t a lot that can be done about them in the short term and certainly not for monthly or quarterly decision-making," says Jennifer Brown, Founder of luxury leather goods brand Pampeano. For this reason, she uses EBITDA for budgeting and to monitor company profitability.
Operating profit, on the other hand, is important for forecasting cash flow, Brown notes. “Depreciation and amortisation aren’t cash movements, where interest and tax payments are, so when determining whether we may need to raise funds or not to cover a cash shortfall, monthly operating profit is more helpful than EBITDA,” Brown shares.
Understanding your cash flow position from month to month is vital, and calculating EBITDA can help you do this. Managing your small business' cash flow alongside vendor and supplier payments can be a tough balancing act, especially when the end of the month approaches. With an American Express® Business Gold Card, you get up to 54 days to clear your Card balance, so you can keep your money in the account for longer, which may help your cash flow¹.
Advantages and disadvantages of using EBITDA
Advantages
EBITDA is a valuable tool for tracking ongoing profitability, unencumbered by expenses that are unrelated to day-to-day operations. Brown calculates EBITDA daily, as it's a quick way to understand whether Pampeano is on track to meet its dividend payments at year-end and to identify potential changes to operating costs if EBITDA is higher or lower than expected.
“If we’re veering off-track, we will scale back investment in activities such as public relations or search engine optimisation, things that typically have a longer-term payback,” Brown notes. “If EBITDA is looking healthier than budgeted, we will tend to invest more in digital marketing as that’s a lever that is relatively quick to change.”
EBITDA is useful if you’re looking to sell your company, raise money from investors, or evaluate business performance against industry peers. “I use EBITDA to compare Pampeano to other businesses of a similar size in the premium consumer brand space, to gauge our performance,” says Brown.
Disadvantages
EBITDA doesn’t consider factors that can impact the liquidity of a business, such as interest costs and taxes, says Hamilton. For example, a business might have a large debt burden with high-interest payments that have a significant impact on cash generation, he explains. By only looking at EBITDA, you might miss the fact that a company is struggling to repay its debts.
Calculating and using the EBITDA margin
The EBITDA margin converts EBITDA into a percentage of the company's revenue. To calculate EBITDA margin, divide EBITDA by total revenue as follows:
EBITDA Margin = EBITDA / Total Revenue
EBITDA margin is useful for comparing the relative profitability of different companies in the same industry, notes Hamilton. "As a result, it is often used by potential investors as a tool to measure a company's operational profitability."
There are so many factors that contribute to a healthy EBITDA, concludes Brown. By calculating EBITDA regularly, Brown says it encourages her team to consider its importance, such as by being more watchful of expenses, and understanding that volume matters for revenue and that gross profit in any transaction matters. "They all feed into this one number that determines the overall health of the business."
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