EBITDA is a good indicator of a company's financial health because it evaluates a company's performance without needing to consider financial decisions, accounting decisions, or various tax environments.
EBITDA is a useful metric for understanding a company's operating performance. This metric focuses on the financial outcome of operating decisions by eliminating the impact of non-operating factors, such as tax rates, interest expenses and significant intangible assets. It's a valuable way to measure a company's financial health and ability to generate cash flow. It’s often used as a basis for financial modeling. This post will cover what EBITDA is, why financial analysts rely on it and how to use it as an analytical tool to evaluate businesses.
How EBITDA works
EBITDA is an acronym for earnings before interest, taxes, depreciation and amortization. One of EBITDA’s key characteristics is that it removes the impact of financing from net income. It doesn't account for the different ways a company can use debt, equity, cash, or other capital sources to finance its operations. EBITDA also excludes the impact of non-cash expenses, such as depreciation and taxes. Depreciation artificially reduces net income, while taxes can vary from one period to the next and can be affected by conditions that are not directly related to a company's operating results. By stripping away these expenses, EBITDA provides a more accurate reflection of a firm's operating profitability.
How is EBITDA calculated?
To make proper use of EBITDA you need to understand each component of the formula:
- Earnings: This is the company's total bottom line — its profit — after paying off all interest expenses, reinvesting in the business and paying suppliers. To determine earnings, subtract operating expenses from your total revenue. Earnings are also called net income.
- Interest: This refers to the cost of servicing debt, but it can also represent any interest paid. This includes interest on loans by banks or third-party lenders.
- Taxes: These are any costs associated with paying local, state and federal authorities.
- Depreciation: This represents the loss in value in tangible assets, such as machinery or vehicles, that’s generally related to use over time. Depreciation measures the utilization of an asset's value by tying the asset’s cost to the benefit it provides over its lifetime. Since depreciation occurs over the asset's lifetime, it represents a deductible non-cash expense.
- Amortization: This is related to the gradual discounting of the book value of intangible assets, such as patents, goodwill and trademarks. Intangible assets are amortized because they have a limited useful life (competitive protection) before expiration. Like depreciation, amortization is a non-cash expense.
Now that you understand the components of EBITDA, the formula for calculating EBITDA looks like this:
EBITDA = Net income + Interest + Taxes + Depreciation + Amortization
EBITDA = Operating profit + Depreciation + Amortization
Here's an example of how to calculate EBITDA. Let's say company X has the following financial information:
- Net income: $20,000,000
- Interest expense: $3,000,000
- Taxes: $4,000,000
- Depreciation + Amortization: $6,000,000
EBITDA = $20,000,000 + $3,000,000 + $4,000,000 + $6,000,000
Company X's EBITDA equals $33,000,000.
How is EBITDA used?
Analyzing a company's financial health using EBITDA became popular in the 1980s at the height of the leveraged buyout era. Since it was common for distressed companies to get restructured, investors and lenders used EBITDA to estimate whether the targeted companies had the profitability to service the debt it would incur during the acquisition.
Today, EBITDA is an effective tool when used correctly and in conjunction with other accounting metrics. It can help business owners and associates make wise decisions about their company's direction, as well as prospective investors and buyers who want to know more about a company's potential future profitability. With EBITDA, all parties can have a general expectation of how a company will perform in the short and long term.
Here are some common use cases for EBITDA:
- Compare companies: If you're considering investing in a company, EBITDA can determine if the company has strong growth potential, particularly when compared with other companies. EBITDA focuses on the essentials, namely operating profitability and cash flow, which makes it easy to compare the relative profitability of two or more companies of different sizes in the same industry. The numbers otherwise could be skewed by short-term issues or disguised by accounting maneuvers.
- Cost-cutting: Calculating a company's EBITDA margin is helpful when gauging the effectiveness of a company's cost-cutting efforts. If a company has a higher EBITDA margin, its operating expenses are lower in relation to its total revenue.
- Determine the debt service coverage ratio: EBITDA is widely used in the financial industry. Bankers use EBITDA to get an idea of how much cash flow a company has available to pay for long-term debt and to calculate a company's debt coverage ratio.
- Business valuation: Generally, a business can be valued by a multiple of EBITDA. Depending on the industry, barriers of entry and the intensity of capital investment required for equipment, the EBITDA multiple is typically between 5x and 10x. If your ratio is high, your company might be overvalued, while a low ratio means it's undervalued. The benefit of the EBITDA multiple is that it considers company debt, which is something other multiples don’t consider, like the price-to-earnings ratio.
What is EBITDA margin?
EBITDA margin measures the income generation relative to revenue and can assess operational efficiency. It measures a company's earnings before interest, tax, depreciation and amortization as a percentage of its total revenue. Essentially, the EBITDA margin shows the profit a company made in a given year. A company's cash profit margin is a more effective indicator than its net profit margin because it minimizes the non-operating and unique effects of depreciation recognition, amortization recognition and tax laws.
Calculating the margin is straightforward — just divide your EBITDA by your total revenue. The formula is:
EBITDA margin = Calculated EBITDA / Total revenue
So, if your EBITDA for last year was $960,000 and you posted $12,000,000 in annual revenue, your EBITDA margin is 8% ($960,000 divided by $12,000,000).
EBITDA margins can range from 1% to 100%, but they are almost always less than 100%. The margin can only hit 100% if a company had no taxes, depreciation, or amortization for the period you’re calculating. Therefore, if your EBITDA margin is higher than 100%, you need to check your accounting records for errors and discrepancies, then recalculate.
What is a good EBITDA margin?
A good EBITDA margin is relative because it depends on the company's industry, but generally an EBITDA margin of 10% or more is considered good. Naturally, a higher margin implies lower operating expenses relative to total revenue, while a low or below-average margin indicates problems with cash flow and profitability.
If your company has a high EBITDA margin it’s in good financial health and presents less risk to borrowers and investors. Conversely, if you have a low margin, it's time to revisit your company's financial obligations and expenses, then make improvements where needed.
It's helpful to calculate and track your company's EBITDA margins to see if they're increasing, decreasing, or remaining relatively stable over time. You can also compare them to the EBITDA margins of other companies within your industry to see how you're performing against the competition.
What is adjusted EBITDA?
Although the difference between EBITDA and adjusted EBITDA is minimal, it is important to understand. Adjusted EBITDA standardizes cash flow and income. It excludes one-time and extraordinary items that aren’t connected to the core operating profit of the business. This includes non-cash expenses, an unrealized loss or gain, assets write-downs, above-market compensation for the owner, rent paid above market value, litigation expenses and non-operating income.
Adjusted EBITDA enables companies to analyze different companies simultaneously, disregarding factors such as industry variances and geography. However, company management can use adjusted EBITDA to support a narrative that frames the company in the best light while disregarding items that investors should factor into their analysis.
EBITDA vs. EBIT and EBT
EBITDA, EBIT and EBT are measures of a company's operating profitability, but they have significant differences.
EBIT: Earnings before interest and taxes (EBIT) is a company's net income before income tax and interest expenses are deducted. By eliminating the effect of interest and taxes, EBIT shows the business's underlying profitability, regardless of its capital structure or the tax jurisdiction it operates in.
EBT: Earning before taxes (EBT), or pre-tax income, represents the operating profits before accounting for taxes. It's calculated by adding tax expenses to the company's net income. EBT is most useful when comparing companies that are subject to different state rates of federal tax rules.
Benefits of EBITDA
It's easy to calculate and widely used: Calculating EBITDA is straightforward as long as your financials are accurate. It's also a popular metric in the business community.
Capital structure neutral: The good thing about EBITDA is that it's neutral to capital structure, lowering the risk of factors that capital investment and other financing variables can affect.
It's a good performance trend indicator: EBITDA is an easy way to compare raw earnings within your own business over time, as well as to determine how you stack up alongside your industry peers.
Allows for easy comparison of two companies: Certain non-operating expenses, like taxes, interest expenses and depreciation, can vary so widely between businesses, industries and geographic regions that comparing one business to another can be challenging. By eliminating these items, EBITDA makes it easier to compare the financial health of various companies.
Limitations of EBITDA
- It isn't a generally accepted accounting principle: Although EBITDA is a good indicator of a company's financial circumstances, it's not a recognized measure by the International Financial Reporting Standards or the Generally Accepted Accounting Principles. This means that calculating EBITDA can vary from one company to the next.
- EBITDA calculations can be deceptive: EBITDA calculations don't consider debt, so companies with a large amount of debt (and interest payments to match) may highlight their EBITDA margins to draw attention away from their debt and enhance the perception of their financial performance. Also, companies with low profitability will emphasize the EBITDA margin as their measurement for success. That's because a company's EBITDA margin is almost always higher than its profit margin.
- Neglects working capital requirements: EBITDA is a decent proxy for cash flows for many companies. However, this profit measure doesn't account for the working capital needs of a business. For example, companies reporting high EBITDA figures may have dramatically lower cash flows once it tabulates working capital requirements, such as inventory, receivables and payables.
- It's no substitute for cash flow: While EBITDA can measure a company's cash flow, it's important to remember that EBITDA and cash flow are not synonymous. That's because it excludes several potential expenses that have a real effect on a business, such as capital expenditures. Treating EBITDA as a substitute for cash flow can be dangerous because investors will have incomplete information about cash expenses.
Other metrics to use alongside EBITDA
EBITDA is a useful metric that can help investors, lenders and management gain valuable insights into a company's performance. However, you also need to consider other metrics, such as:
- Return on investment (ROI): This is the ratio between net profits and the cost of an investment. The higher the company's ROI, the higher an investor's gains per dollar spent.
- Operating cash flow: Operating cash flow is a better measure of how much cash a company generates. Like EBITDA, it adds non-cash charges (depreciation and amortization) back to the net income, but it also adjusts for changes in the company's working capital needs.
- Net present value: This metric considers the time value of money and can provide a better image of the company's profits and financial health.
Analyzing these metrics will provide you with a comprehensive overview of your company's financial situation and performance.
EBITDA key takeaways
EBITDA is a good indicator of a company's financial health because it evaluates a company's performance without needing to consider financial decisions, accounting decisions, or various tax environments. Ignoring tax and interest expenses allows you to focus specifically on operational performance, while ignoring depreciation and amortization provides insights into approximate cash generation. However, you shouldn't rely solely on EBITDA, as it doesn't consider the company's debt expenses, tax impacts and reinvestment, which can affect a company's profitability. Instead, EBITDA should be one tool in your financial analysis tool belt.