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EBITDA, or earnings before interest, taxes, depreciation, and amortization, is a measure of a company’s financial performance and is sometimes used as an alternative to net income. Some analysts believe that EBITDA provides a more accurate measure of a company’s profits and operational efficiency than net income. Others, however, think that EBITDA can be misleading, since it ignores company expenses like debt and depreciation. Here’s what you need to know about EBITDA, how this metric is calculated, and what it can — and can’t — tell you about your business.
What Is EBITDA?
EBITDA is actually an acronym that stands for earnings before interest, taxes, depreciation, and amortization. In other words, it tells you the earnings that a business has generated prior to any debt interest expenses, tax payments, and depreciation/amortization costs of the business.EBITDA doesn’t factor these values in because they are outside of management’s operational control. By adding these values back to net income (gross business income minus all business expenses), many analysts believe that EBITA is a better measure of company performance since it is able to show earnings before the influence of accounting and financial deductions.EBITDA may be calculated by investors or when you’re applying for a business loan to estimate how well your company will be able to pay its bills and maintain or increase net income. Here’s a closer look at each letter of this acronym.
Earnings
Earnings are the profit a business makes off of its core operations. With EBITDA, earnings are calculated by subtracting expenses from total revenue. However, unlike net earnings, EBITDA doesn’t subtract all business expenses. It factors in the cost of goods sold, general and administrative expenses, and other operating expenses. However, it doesn’t subtract costs that are not directly related to the company’s operations, namely interest paid on debt, amortization and depreciation expenses, and income taxes.
Interest
Interest paid on debt is an expense that is excluded from EBITDA, since it depends on the financing structure of a company. Businesses take on different amounts of debt for different reasons. As a result, it can be easier to look at earnings without considering the company’s capital structure.Recommended: Is Interest on Your Business Loan Tax Deductible?
Taxes
Each locality has different tax laws. Depending on where a business is located, it may have a dramatically different tax burden than another company with the same amount in sales. To better compare companies, EBITDA removes the effect of taxes on net income by adding those expenses back into net income. Doing so makes it easier to compare the performance of two or more companies operating in different states, cities, or counties. Recommended: 22 Small Business Tax Deductions
Depreciation
Depreciation is the process of spreading out the cost of a tangible asset over the course of its useful life. While depreciation does cost a business money (as machinery and vehicles do wear out), it’s a non-cash expense that depends on past investments the company has made and not on the current operating performance of the business. Therefore, EBITDA doesn’t factor it in.
Amortization
The difference between amortization vs depreciation is that amortization is the depreciation of intangible items, such as patents or licenses, which also have a limited useful life due to expiration. Amortization is an expense that is reported on a company's financial statements, but, since it isn’t directly related to a business’s core operations, EBITDA doesn’t factor it in.
How Does EBITDA Work?
The core premise of EBITDA is that some expenses are considered extraneous by investors when comparing the operational performance of multiple companies. Those factors include:
Interest
Taxes
Depreciation
Amortization
By eliminating these items (or adding them back to a company’s net income), EBITDA makes it easier to compare the financial health of companies with different capital structures, tax rates, amortization expenses, and depreciation policies.
How Is EBITDA Calculated?
To calculate EBITDA, there are two commonly used EBITDA formulas.Option 1:Start with net income (the bottom line of the income statement), and then add back the entries for taxes, interest, depreciation, and amortization. Net income + Taxes Owed + Interest + Depreciation + Amortization = EBITDAOption 2: Alternatively, you can start with operating income (also referred to as operating profit or EBIT — earnings before interest and taxes). Operating income is the amount of revenue left after deducting the direct and indirect operating costs from sales revenue. If you add depreciation and amortization to operating income, you get EBITDA.Operating Income + Depreciation + Amortization = EBITDA
Pros and Cons of EBITDA
Pros of EBITDA
Cons of EBITDA
A better measure of a company’s operational efficiency than net profit
Does not reflect a company’s actual cash flow
Can give an analyst a quick estimate of the value of the company
Can give the illusion that interest and taxes are optional for a company
Can be used to compare companies against each other and industry averages
Can be used to distract investors from the lack of real profitability
EBITDA can be a valuable measure of a company’s financial performance and operational efficiency. Because EBITDA adds back interest, taxes, depreciation, and amortization (expenses that don’t directly reflect a company’s decisions) to a company’s net income, it shines a light on a business’s ability to generate cash flow from its operations.When calculating EBITDA, the only costs subtracted from revenue are ones that are directly linked to the company’s operations (such as rent, salaries, marketing, and research). Capital structure decisions, which are reflected in depreciation, amortization, and debt expenses, aren’t included. As a result, it gives analysts a way to more accurately compare performance between companies with different capital structures. In addition, business owners use it to compare their performance against their competitors.However, EBITDA doesn’t reflect a business's actual net earnings. And, some analysts are skeptical of EBITDA because it presents the company as if it has never paid any interest or taxes. It also excludes depreciation and amortization expenses. However, machines, tools, and other assets lose their value over time, and copyrights and patents expire. EBITDA fails to account for these costs. EBITDA can also cover up or shift attention away from high debt levels. Indeed, it’s possible to report a strong EBITDA while stating negative profits at the bottom line.Recommended: Cash Flow vs. EBIDTA
EBITDA Example
Coca-Cola Company, 2021 EBITDA example:
Sales Revenue
38,726
Sales Growth
17.25%
COGS (including D&A)
15,508
Depreciation
1,277
Amortization
175
Gross income
23,218
Non-operating income expense
2,076
Interest expense
747
Pretax income
12,425
Income tax
2,621
Net income
9,771
EBITDA
10,697
*Note: All values are in USD millions.Notice how EBITDA is more than net income. Sometimes less honest companies try to persuade investors that they are more profitable than they are by emphasizing their EBITDA number more than their net income number.
History of EBITDA
EBITDA came into prominence in the 1980s when many investors were doing leveraged buyouts of distressed companies that needed financial restructuring. They used EBITDA to calculate quickly whether these companies could pay back the interest on these financed deals.The use of EBITDA increased during the dot-com boom, when analysts and managers used it to show that expensive assets and debt loads were obscuring a company’s actual growth numbers. EBITDA is now commonly used to compare the financial health of companies and to evaluate businesses with different tax rates and depreciation policies.
Alternatives to EBITDA
EBT
Earnings before tax (EBT) measures how profitable a company is before you consider its tax burden. EBT is useful when comparing two companies in the same industry but that exist in different states. By removing tax liabilities, investors can use EBT to evaluate a firm’s operating performance after eliminating a variable outside of its control.
Operating Cash Flow
Operating cash flow measures how much cash is generated by a company's normal business operations. Operating cash flow indicates whether a company can generate sufficient positive cash flow to maintain and grow its operations. If not, it may require external financing.Recommended: How to Calculate Cash Flow (Formula & Examples)
EBIT
The difference between EBIT vs EBITDA is that EBIT (earnings before interest and taxes) doesn’t add depreciation and amortization back to net income. EBIT considers these costs as necessary expenses to consider when analyzing a company.
Revenue
Revenue (also referred to as sales or income) consists of all income generated by a business's core activities before expenses are taken out. It includes both paid and unpaid invoices. When thinking about EBITDA vs revenue, revenue measures sales activity, while EBITDA measures how profitable the business is. Revenue is calculated by adding up income from all business operations, whereas EBITDA takes that revenue and then subtracts expenses in order to measure profit.
Net Income
Net income (also called net earnings) is how much a company makes after subtracting all expenses, including cost of goods sold, general and administrative expenses, operating expenses, depreciation and amortization, interest on debt, taxes, and other expenses. It is a useful number for investors to assess how much revenue exceeds the expenses of an organization.Recommended: What a SWOT Analysis Is and How to Conduct One
The Takeaway
EBITDA is a way to quickly gauge how a business is performing with its core operations. The argument in favor of EBITDA is that many expenses can distract investors from a company’s core vitality. The argument against it is that items excluded from EBITDA — interest, taxes, and depreciation/amortization — are still real items with financial implications that should not be dismissed or ignored.EBITDA can be helpful for seeing how your business performs from year to year and how it compares to the industry averages, but it does not reflect its real income. That's why if you’re exploring business loans or looking to attract an investor, EBITDA will likely be one of several metrics (including your annual revenue, net income, and business credit score) used to gauge the financial health of your business.
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Frequently Asked Questions
What makes EBITDA important?
How is EBITDA calculated?
What is a typical EBITDA?
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About the Author
Lauren Ward
Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
