When it comes to business finances, you’ll need to understand and employ a significant number of financial tools in order to keep things operating smoothly. EBITDA — earnings before interest, taxes, depreciation and amortization — is perhaps one of the most common and fundamental among them.
However, EBITDA can be a bit confusing for new business owners. This metric helps compare your business’s ability to generate money compared to that of your peers, which means it’s essential in measuring your commercial success.
If you’re making an EBITDA calculation for the first time or want to make sure you’re covering your bases, read more to understand what it is and why it’s so important to track.
EBITDA: Definition and purpose
EBITDA is an acronym for earnings before interest, taxes, depreciation and amortization. The EBITDA formula helps define a company’s profitability. Here’s what each term means when broken down:
- Earnings: The money your business brings in during a certain period of time, typically measured in months or quarters
- Interest: Money paid to lenders, in addition to a loan’s principal. This information typically can be found on an income statement.
- Taxes: Any local, state or federal taxes due as part of your business's activities
- Depreciation: Reductions in the value of existing office supplies, inventory or other capital expenditures.
- Amortization: A calculation that measures reductions in loan payment totals over time, as well as reductions in the value of intangible assets, such as proprietary software or other nonphysical goods. The latter is akin to depreciation but applied typically for nonphysical items
EBITDA helps lay bare a company’s ability to generate cash flow. This calculation ignores interest, taxes, depreciation and amortization, exclusively focusing on a company’s revenue and cash flow minus its operating expenses. When you use EBITDA, you’re able to look at a core business performance metric. Having this information is helpful before trying to sell your business or seeking investors for your business, for instance.
There are pros and cons to relying on EBITDA on its own, however, as it doesn’t necessarily factor in a business’s overall financial health and performance. Rather, your company’s EBITDA is but one of several metrics you should calculate to better understand your business financials.
There are other versions of EBITDA, as well; some factor in fewer criteria, while others include more. Each helps you better understand different aspects of your financials or can serve as a better performance metric if it more closely aligns with your current business financial conditions. Here are a few other common EBITDA variations you might want to consider tracking:
EBIT: Earnings before income and taxes. Unlike EBITDA, this calculation does not include the cost of depreciation and amortization from a business’s net profit.
EBIAT: Earnings before interest after taxes. This calculation provides a simpler understanding of a business’s post-tax earnings before interest payments are factored in.
EBITDAR: Earnings before interest, taxes, depreciation, amortization and restructuring/rent. This calculation adds to the classic EBITDA by including any costs associated with reorganizing a business or rent payments.
Why is EBITDA important?
EBITDA is important for several reasons. This metric can be used by a company’s financial team, as well as its investors, analysts or other financial professionals who may want to evaluate the company’s cash flow versus that of its competitors.
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 tough to do. That’s why EBITDA exists: so there’s 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. Plus, lenders may consider your company’s EBITDA when vetting you as a prospective borrower.
How to calculate EBITDA
Calculating your business’s EBITDA is usually a straightforward process, and you can typically do so with the information found on your existing financial reports. The two common methods of calculating EBITDA should arrive at the same conclusion most of the time.
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
Net Income: Total income after expenses and deductions
EBITDA = Operating Profit + Depreciation + Amortization
Operating Profit: Total earnings excluding interest and tax deductions
Although EBITDA is an important metric and may even seem somewhat intimidating, it’s truly as simple as the calculations above. It’s just another way of looking at your earnings before factoring in non-operating cash outflows.
What’s a good EBITDA?
The idea of a “good EBITDA” depends on several factors, rather than a one-size-fits-all figure. For instance, good EBITDA can include industry benchmarks, your own business expenses and your cash flow, but a few additional factors can come into play. Overall, it’s tough to quantify what counts as a “good EBITDA” unless you know your competitors’ EBITDA as well as your own.
You can, however, evaluate your own EBITDA through what’s known as an EBITDA margin. This figure provides you with a numerical valuation expressed as a percentage that is less dependent on broader industry conditions to size up your performance. You can calculate your EBITDA margin with this formula:
EBITDA margin = EBITDA / Total revenue
For example, if your EBITDA is $400,000, and your total revenue is $4,000,000, your EBITDA margin is 10%. An EBITDA margin of 10% or more is typically considered good, as S&P-500-listed companies have EBITDA margins between 11% and 14% for the most part. You can, of course, review EBITDA statements from your competitors if they're available — be they a full EBITDA figure or an EBITDA margin percentage.
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Even though EBITDA is a straightforward metric to calculate and use as a comparison point, it’s only one financial figure among many. In other words, it’s seldom a good idea to rely on EBITDA alone to size up your business financials.
First Republic Bank’s team of financial experts can help fill in the blanks, explore Business Banking solutions and work with you on a plan for financial success that works for the short, medium and long term.