Regardless of the challenges you face as a business, you will always focus on determining and tracking your company's financial health. If you wish to anticipate and exceed customer needs, you must project profitability accurately. If you don't know the future, you can't plan and allocate your resources effectively. Thankfully, EBITDA can help you determine how well your business is doing.
EBITDA is a powerful tool for analysing your business and identifying the next steps to keep your company successful. The term "EBITDA" stands for earnings before interest, taxes, depreciation and amortisation.
EBITDA was developed in the 1980s to assess whether a company could service its debt in the future. Occasionally, this metric is applied to assess companies in financial distress who need restructuring. Over the years, EBITDA has spread throughout various industries and applications. Let’s learn EBITDA meaning before moving on to specifics.
What is EBITDA?
EBITDA measures profitability before interest, taxes, depreciation, and amortisation. To represent cash profit generated by the company, EBITDA strips out non-cash expenses such as depreciation and amortisation, taxes, and debt costs.
EBITDA is a method of calculating earnings that excludes costs that a company cannot control, such as interest expenses and debt finance, taxes, and depreciation, among others. For investors, this is a good tool for comparing the viability and attractiveness of different-sized companies in a given industry.
Generally, companies calculate their cash flow by determining their EBITDA. This is one of the most important indicators of the health of a company.
When deciding how much money to lend to a business, banks and other financial professionals use EBITDA. Although they may use other metrics, EBITDA is consistently reliable and consistent.
Depending on the situation, EBITDA can either be positive or negative. It's considered healthy for a company to have positive EBITDA for a prolonged period. However, even profitable companies can experience negative EBITDA periods.
However, neither IFRS nor US GAAP recognizes EBITDA as a metric. Warren Buffet, for example, disdains this metric because it doesn't account for asset depreciation. For example, if a company owns a large amount of depreciable equipment (and incurs high depreciation expenses), EBITDA does not consider maintenance and sustainment costs.
EBITDA Formula and Calculation
Now that we’ve covered “what does EBITDA mean,” let’s learn how to calculate it. You can calculate EBITDA using two formulas, the first using operating income, and the second using net income.
Using Operating Income
Here is the first formula:
EBITDA = Operating Income + Depreciation + Amortisation
The operating income of a company is the profit after subtracting the daily operating costs. Investors can determine the company's operating performance by excluding interest and taxes from operating income. A business' operating income shows how much money it makes from its operations.
A company's operating income is typically calculated by subtracting sales from operating expenses, such as the cost of goods sold and wages. As operating income is already accounted for before interest and taxes, calculating EBITDA is only a matter of adding D&A.
Using Net Income
EBITDA can also be calculated using the following formula:
EBITDA = Net Income + Taxes + Interest Expense + Depreciation + Amortisation
For the second formula, net income is used instead of operating income, which is calculated by adding back taxes and interest expenses. A company's income statement contains net income, tax expense, and interest expense, just like operating income.
Components of the formula:
The following are the components of the formula:
- Interest is the cost that businesses incur as interest rates fluctuate or loans are repaid.
- Direct, indirect, and state taxes are included in taxes.
- The depreciation expense refers to the non-cash cost of maintenance and wear and tear on an asset.
- The amortization of intangible assets spreads the cost over the asset's life, which can be predetermined. Copies, patents, agreements, contracts, and organization costs could be a part of these assets.
How EBITDA Works With Leveraged Buyouts
A leveraged buyout (LBO) is the purchase of a publicly or privately held company, whether it is a standalone company or a subsidiary of a larger company, using borrowed funds to pay for the purchase. After a leveraged buyout transaction is complete, a private equity firm (also called a financial sponsor) or group of private equity firms (also known as a consortium or private equity group) takes ownership (owns the equity) of the company.
Lenders and investors engaging in leveraged buyouts (LBOs) in the 1980s used EBITDA to measure profitability to determine whether the target companies could meet the debt required for the acquisition. With a buyout inevitably resulting in a new capital structure and tax liabilities, excluding interest and taxes from earnings made sense. A depreciation or amortization expense is non-cash and will not affect the company's debt service ability.
As a result, knowing a target company's EBITDA can give you an idea of its purchase price, how much you might be able to borrow against it as collateral, and even what you might be able to profit from if the company's operations (in terms of EBITDA) demonstrated improvement. If used correctly, EBITDA can be a very useful metric.
In summary, lenders operating in the LBO space look at EBITDA as one of the key factors when making lending decisions. Therefore, EBITDA is often used to quote loans and covenants.
EBITDA vs. EBT and EBIT
Definition of EBIT
As the name suggests, a company's earnings before interest and taxes (EBIT) is a method used to analyse profit without considering tax expenses or the cost of capital structures.
EBIT=Net Income+Interest Expense+Tax Expense
Definition of EBT
The term Earnings Before Tax (EBT) refers to a company's profit before paying corporate income taxes. This calculation was primarily used to estimate the business's profit without considering varying tax rates.
EBT = Earnings before interest and taxes (EBIT) – interest expense
EBITDA vs. EBIT
While EBIT and EBITDA remove debt financing costs and taxes, EBITDA adds back amortization and depreciation expenses. Since we don’t include depreciation in EBITDA, we can use it to compare operating results between companies with different amounts of fixed assets.
The EBIT of a company with high fixed assets is lower than that of a company with low fixed assets because of higher depreciation. The benefit of EBITDA is that it compares the performance of two organisations before depreciation is taken into account.
The terms EBIT and operating income are sometimes used interchangeably, but they are often different (depending on the company). EBIT includes gains and losses from non-core activities, including equipment sales and investment returns, but operating income does not.
EBITDA vs. EBT
Also, EBITDA differs from earnings before taxes (EBT), which measures operating profits before taxes are taken into account. Adding taxes back into net income calculates a company's EBT.
Investors can use EBT to measure a firm's operational performance after removing tax liabilities. Despite their similarities, EBT and EBIT differ in the inclusion of interest expenses in their calculations.
EBITDA vs. Operating Cash Flow
Using operating cash flow is a better way to measure a company's cash flow since it includes changes in working capital, including receivables and payables that use or provide cash. It also includes non-cash charges (amortisation and depreciation) back to net income.
A company's working capital trends play an important role in determining how much cash it generates. In analysing working capital and relying only on EBITDA, investors may miss clues, such as difficulties collecting receivables, that could affect cash flow.
Examples of EBITDA
This is an excerpt from Company XYZ's Income Statement as of 30th March 2021.
Depreciation and amortization of the company amounted to Rs. 63,00,700 as per Cash Flow Statement.
So the EBITDA of XYZ for the Financial Year 2020-2021 would be,
EBITDA = Net Income + Interest +Taxes +Depriciation + Amortisation
=Rs (20,15,36,900 + 5,10,000 + 1,10,99,200 + 63,00,700)
It is worth noting that even the slightest error in the values of these components can significantly impact a firm's profitability. A reliable accounting system and keeping finances up-to-date are crucial to preventing the same.
What Is a Good EBITDA?
EBITDA measures a company's profitability, so higher numbers are generally better. A "good" EBITDA gives investors a better understanding of a company's performance without losing track of the fact that it excludes cash expenses for interest, taxes and eventual replacement of tangible assets.
What Is Amortisation in EBITDA?
Amortisation is the process of gradually discounting the book value of an organization's intangible assets to generate EBITDA. An income statement shows amortization. Among intangible assets are intellectual properties like patents and trademarks, as well as goodwill, which is the difference between past acquisition costs and their fair market value.
Is EBITDA the Same as Profit?
No, EBITDA and profit are not the same. An EBITDA indicator measures a company's profit before taxes, depreciation, and amortisation, while a net profit indicator measures its total earnings after taxes, depreciation, and amortization.
The limitations of EBITDA
Here are a few drawbacks of EBITDA:
● A company's EBITDA cannot be substituted for analysing its cash flow. EBITDA can give the impression that they have more money for interest payments than they really do.
● Furthermore, EBITDA makes a company's earnings appear cheaper than they really are by disregarding the quality of its earnings.
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Frequently Asked Questions
Two main reasons why business owners should understand EBITDA: calculation and evaluation. EBITDA gives a clear picture of a company's value, for one. Secondly, it illustrates the company's value to investors and potential buyers, providing a picture of its future growth prospects.
A company's EBITDA margin measures how many operating expenses are eating up its gross profits. As a result, a company with a higher EBITDA margin is considered to be less risky financially.
An average mid-sized business is priced between three and six times EBITDA.