What is EBITDA? How to calculate and use this key metric

In the world of finance and business valuations, EBITDA is an acronym that often takes centre stage. But what exactly is EBITDA, and why should small business owners care about it? 

In this article, we’ll provide a comprehensive guide to EBITDA, breaking down its importance, usage, calculation, and more. 

By the end, you’ll have a clear understanding of how this financial metric can help you assess your business’s financial health and make informed decisions.

EBITDA, which stands for earnings before interest, taxes, depreciation, and amortisation, is a critical financial metric that provides insights into a company’s operating performance. 

It represents the core profitability of a business by focusing on its ability to generate earnings from its core operations, excluding non-operational factors such as interest and taxes.

Why is EBITDA important?

EBITDA is important because it offers a simplified and standardised measure of a company’s profitability, making it easier for investors to assess financial health, compare businesses, track performance, and conduct business valuations. 

1. Investor attraction: EBITDA is a metric that often captures the attention of investors. It provides a clear and concise snapshot of a company’s profitability, allowing potential investors to quickly assess its financial health. By focusing on core operational earnings, EBITDA removes the noise created by interest and tax factors, making it easier for investors to gauge a company’s ability to generate profits.
2. Simplified comparison: EBITDA serves as a useful tool for comparing the profitability of different companies, particularly within the same industry. Since it excludes interest, taxes, depreciation, and amortisation, which can vary significantly based on factors such as financing choices and tax strategies, EBITDA levels the playing field for comparing businesses. This simplification is invaluable for investors seeking to make informed investment decisions.
3. Tracking performance: EBITDA is a valuable measure for tracking a company’s profitability over time. By consistently focusing on core operational earnings, it allows businesses and investors to identify trends and changes in financial performance. This historical perspective can be essential for making strategic decisions and adjustments.
4. Business valuations: EBITDA plays a pivotal role in determining the value of a business ahead of potential mergers or acquisitions, or restructuring the business financing. In the context of business valuations, EBITDA is often used as a key factor in estimating a company’s worth. By focusing on core profitability, it provides a clearer picture of the business’s earning potential, helping prospective buyers or investors arrive at a reasonable purchase or investment price.

However, it’s crucial to note that while EBITDA is a valuable metric, it should not be used in isolation. It is most effective when considered alongside other financial indicators to provide a comprehensive view of a company’s financial performance.

How is EBITDA used?

And here are some further deep dives into these topics: 

Measuring profitability: at its core, EBITDA helps us figure out how well a company is doing in terms of making money. It does this by looking at the cash the company generates from its main day-to-day activities. In simpler terms, it gives us a clear picture of whether the business is making a profit.

Comparing companies: EBITDA is like a handy tool that investors use to compare different companies on a level playing field. Think of it as a fairness tool. It takes away the influence of things like how a company finances itself or its tax strategies. 

Tracking performance over time: EBITDA isn’t just a one-time snapshot; it’s great for tracking a company’s financial health over time. It helps spot patterns, like whether a company’s making more or less money as time goes on. This information is super helpful for making smart decisions and tweaking business strategies when needed.

So, while EBITDA might sound complex, it’s actually a practical and versatile tool in the world of finance. It surfaces how profitable a company is, compares different businesses fairly, and keeps an eye on financial trends. All in all, it’s an essential in the toolkit of financial analysis.

EBITDA for business valuations

When investors want to know how valuable a company is, they often turn to EBITDA. It’s like a measuring stick for a company’s core profitability, ignoring some of the financial twists and turns.

Why is this important? Well, when trying to put a price tag on a business, the focus should be on how much money it’s making from its main operations. EBITDA helps do exactly this. 

In this way, buyers, sellers, and investors can value the business based on its true earning power.

How to calculate EBITDA

To put this formula into practice, let’s use an example, below.

Understanding EBITDA Margin

EBITDA margin is a frequently used phrase in financial analysis. It represents the percentage of a company’s revenue that turns into EBITDA.

How is EBITDA margin calculated?

EBITDA margin is a common phrase in finance that tells us how efficiently a company is turning its revenue into operating profits. 

It’s a percentage that gives us a sense of how much of each pound in revenue is left after covering the core operating costs.

The calculation itself is straightforward. You take the EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) and divide it by the total revenue, then multiply by 100 to get the percentage.

What’s a good EBITDA margin? Well, that can vary by industry. Generally, a higher EBITDA margin is better because it means the company is efficient at turning revenue into profits. But what’s considered good differs from one industry to another. Some industries naturally have lower margins due to their cost structures, while others can achieve higher margins. 

To figure out if a company’s EBITDA margin is good, it’s often best to compare it to similar companies in the same industry.

EBITDA vs operating profit

At first glance, EBITDA may appear akin to operating profit, as both metrics assess a company’s financial performance. However, a critical distinction lies in what they exclude.

EBITDA stands out by excluding depreciation and amortisation, which are non-cash expenses. This omission prevents these accounting practices from artificially influencing a company’s apparent profitability. By doing so, EBITDA offers a clearer view of a company’s cash-generating capacity.

EBITDA’s focus on core operational earnings makes it a valuable gauge of a company’s operating cash flow. It reflects the funds a company generates from its day-to-day operations, devoid of non-cash accounting entries.

On the other hand, operating profit takes a more comprehensive approach. It includes depreciation and amortisation, providing a holistic picture of the company. While these expenses are non-cash, they represent tangible costs associated with the wear and tear of assets and the amortisation of intangible assets.

In essence, EBITDA and operating profit offer distinct viewpoints. EBITDA excels in assessing operational cash flow, while operating profit provides a broader perspective on a company’s overall profitability, accounting for the real expenses associated with asset depreciation and amortisation.

The challenge of poor EBITDA

When a company faces the prospect of a poor EBITDA, it can be indicative of a lack of profitability within the company – and suggests that the core operations of the business are not generating sufficient earnings to cover its operating costs. 

A low EBITDA figure can also indicate that the company is struggling to generate enough cash flow to meet its financial obligations. This can lead to liquidity problems, making it challenging for the company to pay its bills, invest in growth, or even cover its debts.

A poor score can have broader implications for the company’s ability to access external funding. Whether seeking loans from financial institutions or attracting investors, a weak EBITDA figure can significantly diminish the company’s appeal. 

Lenders and investors often use EBITDA as a key metric to assess a company’s financial stability and growth potential. A poor EBITDA may raise concerns about the company’s ability to meet its financial commitments, making it less likely to secure loans or investments on favourable terms.

In essence, a poor EBITDA is not just a theoretical concern. It can have a cascading effect on a company’s financial health, impacting profitability, cash flow, and its ability to secure the necessary resources for growth and sustainability.

Conclusion

In conclusion, EBITDA is a useful measure of a company’s profitability, particularly in business valuations. However, it should not be used in isolation. Other financial metrics, such as operating profit and cash flow, should also be considered in the evaluation period.

Understanding EBITDA and its role in your business can empower you to make informed financial decisions and drive your company towards greater success.