This detailed article will explain what EBITDA is and what it means for your business. We will discuss EBITDA meaning in detail, why you should use it, how to calculate EBITDA, components of EBITDA, EBITDA margin, EBITDA vs. net income, adjusted EBITDA, and advantages and disadvantages of EBITDA.
What Is EBITDA?
EBITDA is a metric that assesses a company's financial performance on the basis of earnings, revenue, or net income.
Since it emphasizes the financial results of business operating decisions, EBITDA represents the number that helps people determine the worth of a corporation. One can accomplish this by eliminating the effects of non-operating decisions taken by the current management, such as those involving major intangible assets, tax rates, or interest costs.
This leaves a number that captures a company's operating profitability more accurately and that owners, purchasers, and investors may use to compare different businesses. Many people choose EBITDA over other indicators when determining which company is more desirable.
Why Use EBITDA?
In the 1980s, at the peak of the leveraged buyout era, it became common to use EBITDA to assess a company's financial health. EBITDA was primarily used to gauge whether a corporation could pay back the interest associated with restructuring during this time when it was usual for investors to financially reorganize distressed enterprises.
But times have changed, and so has the use of EBITDA. Today, EBITDA is used by people to accomplish the following:
- Banks frequently use EBITDA to calculate a company's debt service coverage ratio (DSCR). This debt-to-income ratio assesses your borrowing capacity and cash flow for business loans. The likelihood of default, or how probable it is that the borrower won't be able to fulfill their contractual debt payment obligations, is measured by this ratio. Find the DSCR.
- Compare businesses. EBITDA is a metric used by investors and business owners to compare firms in the same sector. Business performance compared to sector averages may be standardized using the technique.
- Describe performance in general. Supporters of the EBITDA formula claim that it gives a more accurate picture of how well a company is doing. EBITDA gives a clearer view of a company's long-term potential for some businesses.
How Is EBITDA Calculated ?
The formula for computing EBITDA is as follows:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
or
EBITDA = Operating Profit + Depreciation + Amortization
What Are The Components Of EBITDA?
You must comprehend each element of the formula to apply EBITDA properly. So, here is a detailed description of the components of the EBITDA formula-
- Earnings/Net Income: Earnings are the money your business makes over a specific period. Subtract operating expenses from your entire revenue to get this EBITDA component.
- Interest: The cost of repaying debt is an interest expense. Although it typically refers to an expense, it can also stand for interest earned. The expenditures related to interest are not subtracted from revenue in EBITDA.
- Taxes: We gauge a company's profits before taxes using EBITDA. Operating profit, or EBIT as it is sometimes abbreviated, is another name for earnings before interest and taxes.
- Depreciation and amortization: Depreciation is the term used to describe the decline in the value of tangible assets over time, such as machinery or automobiles. When intangible assets, such as patents, eventually expire, an amortization charge is incurred. Operating profit is increased by depreciation and amortization in EBITDA.
What Is An EBITDA Margin?
The EBITDA margin is an accounting metric used to determine a company's more accurate profit picture. You must first calculate your company's EBITDA, then divide that figure by total revenue to get the EBITDA margin.
EBITDA ÷ total revenue = EBITDA margin
The EBITDA margin demonstrates how much a company's operating costs reduce its gross profit. In the end, the higher the EBITDA margin, a corporation is viewed as less financially hazardous.
EBITDA Versus Net Income
EBITDA measures a company's capacity to generate consistent profits, whereas net income shows the company's earnings. Due to this distinction, net income rather than a company's potential earnings as a whole—where EBITDA comes in handy—should be utilized to calculate earnings per share.
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
Net Income = Revenue – Business Expenses
What Is Adjusted EBITDA
To compare the EBITDA of the two companies, adjusted EBITDA standardizes the cash flow and income and eliminates all kinds of anomalies. Taking one-time, infrequent, and non-recurring expenses out of the equation is crucial when calculating adjusted EBITDA because they have no bearing on a business's regular operations.
Advantages Of EBITDA
Few of the advantages that the metric of EBITDA offers are-
- EBITDA is frequently used by numerous parties, most notably purchasers and investors, as was already noted. They can properly compare business values because it is a language they are quite familiar with.
- Unhelpful variables are eliminated, giving a clearer picture of an organization's operating performance by leaving out variables that vary from business to business, such as interest rates, tax rates, depreciation, and amortization.
- If your financials are precise, it's simple to compute because all of the EBITDA formulae are simple to figure out. Additionally, this makes any agreements simple to grasp for all parties.
- EBITDA is a more credible gauge of a company's financial soundness since it allows investors to concentrate entirely on its baseline profitability.
Disadvantages Of EBITDA
Few of the drawbacks of EBITDA are-
- EBITDA is deemed misleading because debt expenses are not included in the calculation. The information value of a company's actual earnings or liquid assets is not disclosed.
- Business owners frequently use it to hide their lack of sound financial judgment and other financial flaws.
- High-interest financial debt is unaffected by EBITDA.
- When evaluating a company's financial performance, depreciation and EBITDA amortization are not considered actual expenses.
- Companies must use additional financial measures in addition to EBITDA to obtain a more realistic financial picture.
Since EBITDA includes ancillary elements, it is useful for assessing a company's core profit patterns. But both investors and business owners need to employ other, more inclusive financial indicators to arrive at a more thorough financial analysis.