All About EBITDA and How to Calculate It for Your Business

Meta Title: Understanding and Calculating EBITDA for Your Business

Meta Description: Use our free EBITDA calculator to figure out the key revenue metrics for your business and get a complete overview of the EBITDA formula.

“Earnings Before Interest, Taxes, Depreciation, and Amortization”, better known as EBITDA, is an alternative income metric used to measure a company’s financial performance.

But how does EBITDA work and, more importantly, what advantages does it pose for your creative small business? 

Keep reading to uncover the basics of EBITDA to gauge how profitable your small business really is.

What Is EBITDA?

EBITDA (pronounced EE-BIT-DAH), or earnings before interest, taxes, depreciation, and amortization, is a calculation of an organization’s overall financial performance and is used as an alternative to the net income, but only in some circumstances.

EBITDA acts as a proxy parameter for cash flow and lets banks and investors assess how much debt your company can take on its balance sheet.

As a result, this metric gives your investors an indication of your company’s ability to not only generate cash but also service its debt. These are two important considerations from an investment perspective.

While businesses are not legally required to reveal their EBITDA, according to the Generally Accepted Accounting Principles (GAAP), it can be calculated and reported using the data in the company's financial statements.

The Components of EBITDA

To make the right use of EBITDA, you need to understand what each component of the formula means.

• Earnings or Net Income: It is simply what your company earns over a certain period of time, minus the operating expenses. 

  
  

• Interest: An interest expense refers to the cost of servicing debt. It can also represent interest earned, although generally in EBITDA, it is an expense.

  
  

• Taxes: The tax levied by the IRS.

  
  

• Amortization: This is a method of spreading the cost of an intangible asset (such as patents, trademarks, and copyrights) over time, usually the course of its useful life. The goal of amortizing an asset is to match the expense of acquiring it with the revenue it generates.

• Depreciation: Just like amortization, depreciation is also a method of spreading the cost of an asset over a specified period of time. The only difference is that depreciation is used for tangible assets such as manufacturing equipment, business vehicles, and computers. 

Once you are familiar with the components, you can now start calculating your EBITDA.

The EBITDA Formula

The EBITDA formula:

EBITDA = Revenue - Expenses (excluding interest, taxes, depreciation & amortization) 

Simply put,

EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization

For example, let's assume these are the financial details of your business:

• Net income: $1.2 million

• Interest paid: $360,000

• Taxes paid: $112,500

• Depreciation: $80,300

• Amortization: $10,000

If you use the formula, the total EBITDA would be calculated as follows:

$1.2 million + $360,000 + $112,500 + $80,300 + $10,000 = $1,762,800

EBITDA Calculator

Net Income
Taxes
Depreciation
Amortization
Interest
EBITDA

What Is an EBITDA Margin?

The EBITDA margin was developed as an accounting method to calculate a more pragmatic profit picture for your business. To determine your EBITDA margin, you must first calculate the EBITDA and then divide that total by the total revenue:

Here’s the EBITDA margin formula:

EBITDA margin = EBITDA ÷ Total revenue

For example, let's say your company has an EBITDA of $600,000, along with total revenue of $6 million. As per the formula:

$600,000 ÷ $6,000,000 = 10% 

The total EBITDA margin will be around 10%.

The EBITDA margin shows how many operating expenses are eating into your company's gross profit. 

Use of EBITDA Across Industries

The use of EBITDA has spread to a wide range of businesses. Supporters argue that EBITDA offers a clearer insight into a company's operations by eliminating out the expenses that can obscure the company's actual performance.

EBITDA can also be used to analyze profitability among companies and industries, as it eliminates the effects of finances and capital expenditures.

EBITDA is a good measure of the core profit because it eliminates some of the extraneous factors and enables a more direct comparison. However, it can also be misused to make a company's earnings appear greater than they really are.

Companies tend to highlight their EBITDA performance the most when they do not have very impressive (or positive) net income. It's not always a sure-shot sign of a malicious trick, but it can sometimes be used to distract investors from the lack of actual profitability. 

Companies use depreciation and amortization accounts to expense the cost of property, plants, and equipment, or capital investments. Amortization is often used to expense the cost of software development or any kind of intellectual property.

This is one of the main reasons why early-stage tech companies use EBITDA when dealing with investors and analysts.

Benefits of EBITDA

One of the primary advantages of EBITDA is it facilitates comparison between two companies belonging to the same industry but with comparatively higher or lower market capitalization.

Moreover, EBITDA is commonly used by buyers and investors. It is a parameter that they are very familiar with, so they can use it to compare business valuations.

In case you're trying to pay off any debt on your long-term assets, you can use EBITDA as a shortcut to estimate the available cash flow.

The best part about EBITDA is that it eliminates unhelpful variables like company tax rates, depreciation, and amortization, which are unique from company to company. This helps in creating a realistic picture of a company’s operating performance.

As it enables investors to fully focus on a brand's profitability, EBITDA is considered a more reliable indicator due to its financial soundness.

Drawbacks of EBITDA

The main drawback of EBITDA is that it does not fall under the Generally Accepted Accounting Principles (GAAP). And since EBITDA is a "non-GAAP" measure, its calculation can vary from one company to another. 

An important red flag for investors to watch out for is when a business uses EBITDA prominently when it hasn't done so anytime in the past.

This situation can take place when companies have borrowed heavily or are experiencing incremental capital & business development costs. In this circumstance, EBITDA can serve as a distraction for investors.

Other drawbacks include:

• Cost of assets is ignored: Unlike free cash flow, EBITDA ignores the cost of assets, which is an important parameter. 

• Working capital is stripped out: EBITDA also eliminates the cash required to fund working capital and replace older equipment.

• Obscures actual valuation: EBITDA can make a business look less expensive than it actually is on paper.

EBIT vs. EBITDA

EBIT stands for “earnings before interest and taxes” and is used to measure a company's operating income.

To calculate the EBIT, you need to look at the income statement of a business. You would take the total revenue (that is, all the money that the business brings in) and then remove all of the operating expenses.

The expenses include line items such as the cost of goods and production, salaries, rent, along with associated overhead, depreciation, and amortization.

The following formula is used to calculate EBIT: 

EBIT= Net Income + Interest Expense + Tax Expense

Net Income
Interest Expense
Tax Expense
EBIT

Earnings before tax (EBT) shows the operating profit generated before taxes, while EBIT excludes both taxes and interest expenses. EBT is calculated by taking net income and adding the taxes back to calculate the profit. 

By removing tax liabilities, investors can use EBT to analyze a company's operating performance after eliminating the variables ( which are outside of its control). In the United States, this is the most useful parameter for comparing companies that might have different state taxes or federal taxes. 

EBT and EBIT are similar to each other, while both are variations of the EBITDA parameter.

In Closing

EBITDA is a quick way to measure an organization’s financial health. It's a useful formula for businesses with long-term growth potential that are looking for investors. 

However, spending all your time and resources on calculating EBITDA and other business expenses doesn't leave you any room to expand your creativity and thrive in your niche.

Luckily, an all-in-one bookkeeping and tax solution like Fincent can help you out. We simplify money management for your small business by looking after your accounting and tax preparation, meaning you are free to do what you do best: create.