What is EBITDA? 11 Things You Need to Know
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Originally Posted On: https://theaccountancycloud.com/resources/blogs/what-is-ebitda-11-things-you-need-to-know
This blog will build an understanding of EBITDA to establish its role in your business and provide insight into its importance in terms of operating and valuing companies.
1. What Does EBITDA Mean?
The best place to start in understanding EBITDA and what it means for your business is to explore the acronym.
In short, EBITDA is a measure of the financial performance of a company. It shows the earnings before expenses are applied and gives insight into the company’s health before financial and accounting decisions are applied. This is one reason why keeping on top of your bookkeeping is so important!
EBITDA is a universal metric in business. Whether you’re running a company or researching for a potential investment, EBITDA is a powerful tool. This blog will help you understand EBITA and show how it relates to other metrics and how investors and business leaders make decisions based on it.
2. How is EBITDA Calculated?
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortisation
Net Income: Net income (sometimes called net earnings), can be understood as the sales minus costs of goods sold, expenses, interest, tax and depreciation. This value appears on a company’s income statement. Net income can be understood as a gauge of a company’s overall profitability.
Interest: Interest expenses are the costs sustained by a company for any borrowed capital, for example, interest expenses on lines of credit or corporate bond issuances. Interest rates for companies are based on both the macro-economic climate and the past and forecasted financial performance of the company in question.
Tax: Taxation is essentially a financial duty imposed on it by a government or authority. Taxes are not directly linked to services rendered and do not require consent and taxation is compelled through legal recourse. Taxes can be applied to physical assets, events and transactions.
Depreciation: Depreciation is the accounting technique that distributes the cost of a physical asset over its entire useful life. For example, expensive machinery does not have to be accounted for entirely in the year it is purchased, instead, its cost can be spread out over its lifetime. This is desirable for accounting and tax purposes.
Amortisation: Amortisation can refer to the paying down of a loan. An amortisation schedule is the repayment plan of the capital and interest payments on corporate loans. Amortisation can also describe the process of expensing certain intangible assets, such as trademarks and copyrights, in this situation amortisation is similar to depreciation as described above.
EBITDA itself is not a figure that will appear in a company’s income statement and there is no legal requirement for companies to disclose it. However, it is something that can be derived from the information found in financial statements. All the parts (described above) are found in income statements and therefore it is a straightforward exercise in calculating EBITDA yourself, although many online platforms will have this information readily available, such as Yahoo Finance.
Before we calculate an example of EBITDA, you may have also heard of EBIT. EBIT is earnings before interest and tax is deducted and is seen as an indicator of profitability. EBIT and EBITDA are both important metrics when analysing a company, but EBITDA can provide a “truer” sense of profitability in industries with high levels of debt or fixed assets as it doesn’t include depreciation or amortisation.
EBITDA, a worked example for a fictional company.
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortisation
EBITDA = £32.34bn + £4.30bn + £9.75bn + £7.88bn + £6.39bn
EBITDA = £60.66bn
But is EBITDA better than EBIT? Well, that depends on what purpose you need a metric for and both have their advantages. In industries with high capital expenditure and cash flows separated by long time periods, EBITDA can be misleading. This is because past capital expenditure is added back on and this might not be a true reflection of company performance. In circumstances such as this (oil and gas production, mining etc.), EBIT may be more appropriate to perform an analysis.
Now we’ve looked into the parts, we can ask this question again, “what does EBITDA mean?”
3. What does EBITDA mean to investors and business leaders?
EBITDA allows a management team to get a clearer idea of a company’s value and allows investors and other professionals to see its underlying worth and profitability. It can be useful as a metric to compare profitability between competitors and other industries/sectors. Its usefulness in conducting comparisons is specifically related to the fact that EBITDA strips out the effects of financing, individual countries taxation environments and other accounting decisions, allowing for a clearer indication of earnings. However, EBITDA shouldn’t be the only measure of company performance as it can hide high levels of debt and other warning signs.
When comparing the profitability of one company to another, can help you understand the businesses’ cash flow. For example, if a company’s EBITDA is negative, it has a poor cash flow. A positive EBITDA, however, is not necessarily a sign of good profitability. You should be careful to make sure that the EBITDA has been calculated with similar factors included/excluded in your comparison. Accountancy techniques differ between businesses operating in different environments and some expenses/costs may be treated differently, leading to a comparison that isn’t exactly “true”. Enlisting the help of financial experts in accountancy and tax can help with exercises such as this.
EBITDA forms an important part of the financial lexicon, especially when discussing business valuations. So, understanding and being able to apply it successfully will give you an advantage when discussing company cash flow, valuations and exits.
4. Drawbacks of EBITDA
While there are many proponents of EBITDA, some people think that the calculation can be deceiving and misrepresent profitability. Like all business metrics, they are only as useful as the observer’s conclusions.
One criticism of EBITDA is that it doesn’t allow for an accurate account of working capital, (liquidity). For example, a company with lots of fixed assets that would be difficult to convert to cash would have low liquidity (undesirable) but might be profitable and show a healthy EBITDA. Once tax and interest are accounted for (and these are expenses that must be accounted for), the company may be under pressure and not in such a healthy position after all.
By adding back depreciation and amortisation you can also be presented with a biased picture of how much cash a business has to service its interest commitments. In this way, EBITDA can be manipulated by accounting for depreciation to artificially inflate profit. For example, companies with high capital costs will have a higher EBITDA, as the depreciation of this capital outlay is adding back, making it look stronger than it actually is.
5. Why is EBITDA Valuable?
EBITDA as a metric is comparable to cash flow. It displays the cash a company has received and therefore has available to use in the future.
Conducting company analysis with EBITDA can allow you to:
- Determine the cash available to a company for it to service debt and re-invest.
- Understand whether the company has a positive or negative cash flow.
- Conduct meaningful competitor analysis and comparisons.
EBITDA is valuable in that it provides an understanding of whether the business can successfully generate income (and how this changes over time). If investors can see that a company is able to bring create income, before other factors are taken into consideration, then they will be more attracted to the company from an investment perspective.
6. Understanding EBITDA
The EBITDA figure can be best understood as cash received by the company over the reporting period. In this sense, the higher the EBITDA figure the better. A high number indicates that the business is operating profitably, earnings are stable and there are no cash flow concerns. A low figure would be a cause for concern, as expenses and costs have not yet been factored in at the EBITDA stage. A low figure could suggest that the company is unable to meet its financial obligations, or at least it has low liquidity to be able to react to unforeseen circumstances.
EBITDA can be negative, but this would be a sign that operationally the company is in trouble. In this situation, the company would want to look at its fixed/recurring costs and make savings, such as renegotiating leases and utility contracts.
7. Improving EBITDA
The EBITDA figure is presented as the net income plus other expenses added back on. This doesn’t just present businesses with an opportunity for an accountancy trick to inflate their profitability, but it allows the business leaders to show off their true underlying potential. To grow the EBITDA figure, you could:
- Grow sales revenue.
- Increase amortisation.
- Increase depreciation.
- Decrease the cost of goods sold.
- Decrease rent/building costs.
- Decrease salaries/staff costs.
- Decrease costs associated with utilities.
Other things you may want to consider are maintaining consistent pricing and not offering discounts. By selling based on the value of your product/service and not on attracting customers with low prices, you can increase sales revenue.
Reduce and optimise non-essential expenses such as travel and corporate entertainment. The post covid environment will place less value on corporate entertainment/travel, especially in terms of face-to-face meetings. The ubiquity of virtual meetings provides an opportunity for these costs to be minimised, especially as virtual meetings have proved to be just as effective as in-person meetings.
Inventory management is important, producing more products than required incurs storage costs and these can be material when rent, staff and utility expenditures related to storage and transport are considered. Streamlining the production and distribution of products and services can free up capital and provide a boost to EBITDA.
Reduce fixed costs. All businesses can benefit from this exercise. Looking at ways to be more cost-effective and efficient. This can be as simple as outsourcing building security or cleaning, purchasing premises to reduce outlays on rent, and everything in-between. Saving money on the costs of goods sold, staffing and back-office costs, along with non-essential cost savings will all improve EBITDA over time.
8. Using EBITDA Multiples
Investors and finance professionals talk about multiples a lot. Multiples, in simple terms, reflect the marketplace’s perception of the potential growth of a business. If two companies operate in the same environment, with similar characteristics and products/services, you would expect the multiples to be similar. Understanding the meaning of the EBITDA multiple can be understood by answering the question, “how do you value a company?”.
Valuing a company is a lengthy and complicated process and depends on many different factors. Broadly speaking there are two main approaches:
- Calculating the present value of future free cash flows; and
- Reviewing market comparable transactions.
Multiples play a big part in method number 2. To take an example, if a local café sold for £100,000 recently (its Enterprise Value (EV)), and we know from its financial statements that its EBITDA last year was £20,000, it had an EV/EBITDA multiple of 5.0x.
EV / EBITDA
£100,000 / £20,000 = 5.0x
Now if you were selling a café in the same town and your EBITDA last year was £40,000 the comparable transaction multiple can be applied to your transaction.
5.0x £40,000 = £200,000
Your café would have an enterprise value of £200,000 using this method.
Using EV/EBITDA multiples is a simple way to discuss a valuation. The EV in the calculation is the cost of taking over that company today. In reality, there are many other factors that are significant when valuing a company. It is a starting point though and allows founders/managers to look at the value in the market and see where they fit in. If conditions at your business are better than at a recent company that has been bought, you can say that you would expect a higher valuation multiple. In mature markets, there is usually a long history of comparable transactions in order to explore the multiples that similar companies attract.
If you wanted to calculate the multiple for a company without a recent comparable, or if you just wanted to calculate an accurate multiple at a given time you can perform the calculation as set out below.
EV = Market Capitalisation + Total Debt – Cash
Market capitalisation is equal to the current stock price multiplied by the number of outstanding shares.
Total debt is the combined total of short-term and long-term debt.
Cash (and cash equivalents), in other words, the liquid assets available to the company.
EV from this method is then factored into the ratio EV / EBITDA and the multiple is derived.
The EBITDA multiple is not just useful in terms of valuation, it can also be useful in understanding differences between companies. For example, it can be used to look at disparities between capital structures and tax regimes as well as operational efficiencies.
9. EBITDA Adjustments
We have just seen how EBITDA multiples can be used in valuations. But can EBITDA be adjusted in order to give a truer value to your business? The short answer is yes. EBITDA is open to manipulation and that is why care should always be taken when comparing companies that the same financial line items are included/excluded in the calculation.
The open market value of a company, calculated by using the EBITDA multiple can result in a blunted output. To produce a more nuanced multiple that better reflects the value of a company certain adjustments can be made.
Typically, these can include:
- Salaries, pensions and bonuses. These can be adjusted to reflect the market rate.
- Unusual income, costs and expenses. These may be one-off and not be expected to occur again. If so, these values can be normalised to reflect more typical income and expenses.
- R&D and maintenance costs. These costs attract certain tax reliefs and so it is important that this is accounted for. If not, an adjustment may need to be made so that it doesn’t impact the valuation.
These adjustments would be made not to mislead, but rather in order to produce a clearer value for the multiple and therefore the company. If a company is being valued for sale, the sophisticated analysis will be performed using the financial records of the company and appropriate adjustments will be made and these will always be clearly outlined to investors.
10. What is EBITDA Margin?
The EBITDA margin is essentially a gauge of a company’s operating profit as a percentage of revenue. As mentioned above, EBITDA strips away the interest, taxes, depreciation and amortisation factors and provides a way to measure earnings by focussing on the essentials of the business before these costs are considered. The EBITDA margin is calculated by:
EBITDA / Total Revenue = EBITDA Margin.
This ratio provides a way to compare profitability between companies. The attraction of using EBITDA margin is that by using EBITDA, a small company can be compared against a larger company, and the numbers will not be biased by accounting practices or higher levels of debt amortisation.
A high EBITDA margin means low operating expenses in relation to the total revenue of that business. An investor analysing companies will favour higher EBITDA margins.
Because EBITDA is calculated before accounting decisions and costs are considered, EBITDA margin measures cash profit over a given time period. This is considered an effective indicator of company performance as the effects of tax, amortisation and depreciation are diminished. This is important for companies that operate in conditions of high debt and/or high capital outlays on equipment.
Monitoring EBITDA margin can also be useful when understanding how successful cost-cutting measures have been in a company.
11. EBITDA and Gross Profit
Gross profit is the amount of revenue that is profit after production expenses are taken into account.
(Revenue – Cost of Goods Sold) = Gross Profit
Gross profit considers the cost of goods sold or the expenses related to the selling of the product or service. Gross profit doesn’t include costs and expenses such as tax and interest.
Gross profit is useful for businesses, especially those that are concerned with selling a product, as it shows the portion of each pound of revenue that the business retains.
This is different to EBITDA, although both show the earnings of the company in question the company profit is calculated in separate ways.
- EBITDA and gross profit are business metrics that are used to measure profitability in companies by removing different costs and expenses.
- EBITDA shows profitability before interest payments, tax, depreciation and amortisation.
- Gross profit shows profitability after subtracting the costs incurred when making a product or providing a service.
- EBITDA does not appear on income statements but can be calculated using income statements.
- Gross profit does appear on a company’s income statement.
- EBITDA is useful in analysing and comparing profitability.
- Gross profit is useful in understanding how companies generate profit from the direct costs of producing goods.
One metric is not better than the other and the differences are important to understand in order to use them effectively. With gross profit only operating expenses are removed, when considering EBITDA non-cash items such as depreciation are added back onto net income.
EBITDA helps users to understand companies before management decisions, financing arrangements and accounting are carried out and shows the underlying financial performance. Gross profit is used to understand production efficiency and relates to direct production costs.
As we have seen above, EBITDA is a simple business metric that can be put to some sophisticated tasks, such as when valuing businesses. Its use in financial analysis and transactions has become widespread and it is important to be familiar with what it means, both to you and to other people.
Using a company’s EBITDA can allow you to establish the cash available to it, (possibly to service debt or re-invest), understand whether the company has a positive or negative cash flow and conduct meaningful competitor analysis.
EBITDA is valuable to us as a business metric as it provides an indication of whether the business can successfully generate income or not.
There is a downside to EBITDA though, care is needed when calculating EBITDA as some companies will include/exclude different costs and expenses. Accounting techniques, especially when it comes to depreciation and amortisation, can be used in order to “optimise” EBITDA and make it seem more attractive. As with everything in business, EBITDA is only one line of information and others should be used alongside in order to build up a true picture of the financial health, or value, of a company.
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