EBITDA Explained
EBITDA is one way to measure a company’s ability to generate cash flow. Unlike net income, it does not account for the company’s interest and tax payments, amortization costs, and depreciation. In doing so, it strives to capture a business’s cash earnings before the interference of expenses.
EBITDA is important because it is often correlated with a company’s value. So, if you are considering a sale of your company, understanding your company’s EBITDA can give you insight into what your business is worth.
Definition
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. While alternate measures of profitability like net income are important to consider, EBITDA is an industry standard metric. To calculate EBITDA, interest, taxes, depreciation, and amortization costs are “added back” to net income.
How do you Calculate EBITDA?
Represented as an equation, calculating EBITDA is as follows.
EBITDA= Net income + Interest + Taxes + Depreciation + Amortization.
To calculate EBITDA, one must first calculate net income. There are a variety of ways to calculate net income, such as:
Revenue – Cost of Goods Sold – Expenses
Gross Income – Expenses
Total Revenues – Total Expenses.
It is important to note that because the interest expense is added back later in the EBITDA equation, interest does qualify as an expense when calculating net income. Other expenses include rent, utilities, employees’ wages, taxes, etc.
Why Does It Matter?
In short, other metrics like net incomedo not capture the full picture of a business’ ability to generate cash flow. Consider the following example: one company owes more debt than the other, so it will have higher interest payments, and thus report a lower net income (all else being equal). Only comparing EBITDA to net income values reveals that the two companies generate similar cash, but simply differ in capital structure.
The same is true for tax payments. Tax payments can differ for a variety of reasons, from accounting practices to corporation-specific regulations. If the company were to change its corporate form, its tax payments would change, causing an increase or decrease in net income. This is another reason why prospective buyers want to know EBITDA— upon purchasing the company, they could change net income by changing tax practices.
Depreciation and amortization is another expense that EBITDA does not account for. These charges are particularly important to understand because they are non-cash expenses. In other words, the income statement shows an expense, but no cash is paid. Depreciation speaks to a physical asset’s declining value over time: for example, a piece of heavy machinery’s wear and tear. Amortization pertains to nonphysical assets that add value to a company, like intellectual property rights. Just as the machinery has a finite lifespan, so does a patent. This declining value over time theoretically reduces net income, but as it does not impact cash going out, it is added back to net income to calculate EBITDA.
EBITDA vs. Gross Profit
Both EBITDA and gross profit seek to measure a company’s profitability, but they do so in different ways. While EBITDA strives to capture total incoming cash flow, gross profit aims to determine the profitability of the specific products or services sold. Effectively, gross profit tackles the question: how much customer demand is there for this company’s products or services?
Gross profit is a company’s revenue subtracted by the costs of production. These costs include materials, shipping, equipment, utilities, and labor if the expense fluctuates based on production. However, it is important to note that operating expenses that are not direct costs of production are not included. For example, employees in sales and marketing would be included in business expenses, but not as a cost of goods sold— therefore, this expense would not be counted as a production cost.
When 1719 Partners values businesses we take into account many factors including but not limited to gross profit margin (higher is better), revenue growth rate, and EBITDA. Because EBITDA is such a key metric, it is important for every business owner to fully grasp what it is and how it is calculated.
EBITDA vs. EBIT
As you might expect, EBIT is a simplified version of EBITDA. EBIT stands for earnings before interest and taxes. EBIT is important because it measures a company’s ability to fund ongoing operations. To calculate EBIT, you would add net income, taxes, and interest.
EBT is a further simplification: earnings before taxes. Unlike EBIT, it does include interest.
Operating Cash Flow vs. EBITDA
Operating cash flow and EBITDA both “add back,” or do not include, depreciation and amortization expenses. Unlike EBITDA, though, operating cash flow (“cash flow”) does account for interest and taxes. This is because interest and taxes is cash regularly flowing out of the business, just as revenue is cash flowing in. Cash flow is important because it shows how well a business is able to fund ongoing operations, such as paying for labor, project materials. In other words, it is an important piece of business health.
Why do investors look at a company’s operating cash flow? If operating cash flow is not sufficient to fund ongoing operations, the business either needs to grow revenue, cut expenses, or secure additional funding to remain a going concern. Together, both metrics help discern how well a business’s products or service offerings generate cash.
What is Adjusted EBITDA?
Adjusted EBITDA is used to more accurately compare one company to another in a similar industry. Because every company has occasional abnormal expenses, the adjusted metric seeks to remove these. By adjusting for these expenses, investors can compare companies in the same industry more easily. What counts as an expense to be adjusted or normalized? Common examples are one-time startup costs, real estate repairs, non-recurring legal fees, and insurance claims. Normalized values can also include an owner’s personal expenses (if these are done through the business), or bonuses.
Adjusted EBITDA is not used alone to evaluate a company, but rather in association with other metrics. Nevertheless, this step “levels the playing field” between companies when running a comparison.
How to Calculate Adjusted EBITDA
The first step of calculating adjusted EBITDA is to calculate EBITDA itself (equation provided above). After this step, adjustments are simply added or subtracted. The equation looks like this:
EBITDA +/– A = Adjusted EBITDA
How could abnormal expenses be both added or subtracted? It depends on the expense in question. For example, excessive compensation (above fair market value for the industry and role) would be added back— in other words, this expense is abnormal because it is unnecessary. An expense that a company does not have, but that they should have, would be subtracted. An example of this might be an owner who does not pay themselves but who works at the business. But they would need these services to be comparable to similar companies (and probably for their future success as well)— thus why this value is subtracted.
How Many Times EBITDA is a Company Worth?
Here is where the purpose comes full circle. By multiplying a company’s adjusted EBITDA with what is called the “enterprise multiple,” one can approximate what the company would be worth in a sale. The enterprise multiple is dictated by a variety of factors like the company’s industry, capital cost, company size, how well the business is running, revenue growth, and statistics based on recent comparable sales.
Due to these many factors, the enterprise multiple evolves over time. Determining a multiple is more art than science and two people looking at the same company may come up with different multiples. If you are considering selling, it is important to understand both your company’s adjusted EBITDA and the enterprise multiple. Without this knowledge, it is difficult to determine what your company is worth.
Understanding EBITDA is an important step if you are considering a sale of your company. If you have further questions or are curious how the metric could be used to evaluate your company, feel free to contact us.
EBITDA FAQ
What Does EBITDA Stand for?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.
How to Pronounce EBITDA?
EBITDA is pronounced ee-bit-dah.
How to Find EBITDA?
To find EBITDA, you calculate it. EBITDA is calculated as follows. EBITDA= Net income + Interest + Taxes + Depreciation + Amortization.
What is a Good EBITDA?
A good EBITDA is generally defined as having a higher EBITDA margin. An EBITDA margin is calculated as follows:
EBITDA Margin= (EBITDA)/Revenue.
As a rule of thumb, the higher the margin, the greater the company’s profitability— which is more desirable to prospective buyers. However, what margin is “good” depends greatly on the company’s industry as well as specific circumstances.
What is EBITDA Multiple?
The EBITDA multiple combined with a company’s EBITDA can determine its enterprise value, or what the company might be worth in a sale. The EBITDA multiple is calculated as follows:
EBITDA Multiple= (Enterprise Value)/EBITDA
A higher multiple is better and indicates the company is valuable, but what makes a good multiple varies by industry. For example, companies in the technology sector typically enjoy higher multiples while manufacturing companies often have lower ones. For more on EBITDA multiples and business valuation, see this blog.
Do a Company’s Margins Matter in EBITDA?
A company’s margins do matter in EBITDA. Generally, a higher EBITDA margin is better, indicating that a company can generate more profit relative to its revenue. A higher EBITDA margin also means the company has extra earnings at its disposal to invest in future growth. However, how good an EBITDA margin is depends greatly on the company’s industry and the company’s specific situation. Some industries support higher EBITDA margins than others.
