What is EBITDA? The Formula Explained and How to Calculate It

Investors and business owners often need to analyze either potential investment companies or their own enterprises. In most cases, old-fashioned math formulas are the way to go, as they can boil down the oftentimes complex numbers on a company’s income spreadsheets to a simpler value to show owners or investors how things are really going below the surface.

One of the most commonly used formulas is the EBITDA formula, which serves as a kind of quick and dirty check of a company’s profitability within a given timeframe. But while this can be useful, EBITDA isn’t a one-size-fits-all solution for all analytical needs.

Let’s break down the EBITDA formula in a little more detail and show you how to calculate it for your own business or any future investment.

What Does EBITDA Stand For? 

EBITDA is an acronym that stands for “earnings before interest, taxes, depreciation, and amortization”. That’s quite the mouthful! But break it down – all it provides are the earnings for a company organization before other factors change that number.

Put another way, EBITDA measures company profitability above all else.

But don’t worry too much. Put simply, EBITDA is a measure that showcases how well a company is performing financially overall. Many financial advisors and investors will use EBITDA analysis to investigate a company, as opposed to simpler metrics like net income, since the EBITDA formula can reveal additional information.

What is the EBITDA Formula Used For? 

As mentioned, the EBITDA formula is used to investigate a business’s overall financial performance. In some ways, it’s quite similar to other metrics like the net income of a company or net profits after expenses.

However, EBITDA is not a one-size-fits-all solution. The analysis can mislead you at times since it doesn’t consider certain costs, like the cost of capital investments and equipment. Furthermore, the EBITDA formula doesn’t include any expenses that are associated with debt.

Even with these downsides, EBITDA can serve as a (relatively) precise measure of overall corporate performance. It boils down all of a company’s earnings before accounting and financial deductions heavily shift those earnings as reported.

The EBITDA Formula Explained – How to Calculate EBITDA for Your Company

EBITDA is found by looking at a formula. Fortunately, it’s easy to calculate the EBITDA since every necessary piece of information can be found on company income statements and balance sheets. Let’s break it down.

EBITDA’s formula is basically:

  • Net income 
  • Interest 
  • Taxes 
  • Depreciation 
  • Amortization

By adding up all of the above values, you’ll get your EBITDA. You can look at the EBITDA formula another way by thinking of it as EBITDA = Company operating profit + depreciation + amortization.

  • Company net income is self-explanatory – it’s how much money your company brought in overall.
  • Interest expenses are excluded from EBITDA analyses. That’s partially because different companies have different financing structures, so interest expenses will not be considered for this basic calculation.
  • Taxes also vary significantly and will depend on where your business operates. While taxes don’t necessarily affect a company’s profits or performance relative to its effort, they can still be a deciding factor when comparing multiple businesses.
  • Depreciation is essentially how much value a company’s tangible assets are lost over time. For example, vehicles and other heavy equipment depreciate over time as it is used. You add depreciation expenses every time you do an EBITDA analysis.
  • Amortization expenses apply when intangible assets expire or lose value, such as patents. With EBITDA, amortization is added back to total operating profits.

Ultimately, EBITDA is both a simple and complex formula. Let’s take a deeper look at it with an in-depth example.

Imagine that your company has the following financial metrics to plug into the EBITDA formula.

  • Net income: $1.5 million
  • Interest paid: $270,000
  • Depreciation: $180,000
  • Amortization: $50,000
  • Taxes paid: $100,000

All you have to do to find the EBITDA of this hypothetical company is to add all of those values together. Do so and you get a combined EBITDA total of $2,100,000.

What Does the EBITDA Say About a Company? 

In general, it’s a good idea to use EBITDA analysis as a comparative tool to cash flow. When an analyst uses EBITDA, they can get a really quick estimate for the overall value of a company. They can even perform an EBITDA valuation range to see short-term growth projections or to see how profitable a company is in a given quarter or another short-term timeframe.

When companies aren’t making profits, either due to certain expenses or if they are a startup and have not reached full productivity, investors can then use the EBITDA to evaluate a company when determining whether to give it a cash injection.

Since the EBITDA formula is pretty straightforward, investors can perform multiple analyses at once and compare similar companies against one another quickly and cleanly.

Downsides of Using EBITDA

While certainly has some value, especially for bootstrap analysis, there are some reasons to utilize other financial analysis tools and formulas in its place.

  • For starters, EBITDA isn’t one of the so-called “generally accepted accounting principles” or GAAP. This means that accountants may not use it to make serious analyses or to measure the long-term financial performance of a company. This also indicates that the EBITDA measure can vary heavily from one company to the next, even if they are outwardly quite similar.
  • If you’re an investor, you should be wary of companies that provide EBITDA metrics more quickly than other metrics like cash flow or net income. EBITDA metrics are much more flexible, meaning they can distract from certain problem areas or issues with the company at large.
  • EBITDA does not explicitly represent cash earnings for a company. Specifically, it doesn’t take into account the cost of company assets. In other words, EBITDA essentially acts like the assets and financing for a company to operate every day don’t cost a penny, which is almost never true.
  • EBITDA furthermore does not take into account any cash required to fund employees or other “working capital”, or the cash required to replace old or broken equipment.
  • Companies that prefer to use EBITDA analyses may use different earning figures as their starting points. This, again, means that companies may try to trick investors or accountants by using EBITDA metrics in place of other options.
  • Lastly, EBITDA analysis can sometimes make a company appear to be much more expensive than it truly is. This can actually ruin a company if it fails to draw in investors or causes trades of its stock to drop heavily.

There’s a really famous example that highlights the inherent folly of only relying on EBITDA metrics for valuation.

At one point, Sprint Nextel, a well-known telecom operator, saw its stock trading at 7.3 times the forecast EBITDA for the company. This quickly rose to 20 times its forecast operating profits, then 48 times its net estimated income. This resulted in lots of people losing money over trades and Sprint Nextel being criticized for using EBITDA as a forecasting metric in the first place.

What’s a “Good” EBITDA? 

To determine whether your company has a good EBITDA, you’ll actually need to find the EBITDA margin.

The EBITDA margin is effectively a quick picture of short-term profitability or operational efficiency for a company.

You can do this quite simply by calculating EBITDA divided by company total revenue or EBITDA / total revenue. Then you can compare your EBITDA to other companies. Alternatively, accountants can perform this analysis by using the above formula for two similar companies.

Say that one company had an EBITDA of $800,000 and total revenue of $8 million. This margin ends up being 10%.

Meanwhile, another company has an EBITDA of $960,000 with total revenue of $12 million. This margin is just 8%. Thus, the second company has a smaller margin than the first company, and the first company has a little more profit potential overall.

Summary

All in all, EBITDA is just one more analysis tool you should have in your kit when either analyzing your own company’s operational effectiveness or when comparing two companies against one another when deciding whether to make an investment. However, EBITDA is not a replacement for other analysis metrics like cash flow, net profits, and more.

It should only ever be used in conjunction with other analysis methods. Do not rely on the EBITDA formula to give you a full picture of a company’s total profit potential or operational efficiency.

Fortunately, you can find more information about good investment analysis info and formulas right here at Seek Capital! Check out our other blog articles today for more guidance, or contact us to explore business lending options!

 

Sources

https://www.investopedia.com/terms/e/ebitda.asp#:~:text=EBITDA%20is%20essentially%20net%20income,of%20financing%20and%20capital%20expenditures.

https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-ebitda/

https://www.accounting.com/resources/gaap/#:~:text=Generally%20accepted%20accounting%20principles%2C%20or,approved%20accounting%20methods%20and%20practices.

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