To thrive as a business, one needs to know the state of its financial health. One popular metric is EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation and Amortization. But what is EBITDA’s meaning, and what is its purpose? This brief guide will give you the fundamental knowledge you need.
EBITDA: What is its meaning
First developed in the ‘70s, EBITDA is a business analysis metric that measures a company’s profitability from its core operations. It’s a key indicator of a business’ performance. And for many financial analysts, it also gives a quick picture of a company’s available cash flow.
The E in EBITDA stands for earnings from a company’s products, services or investments. I or interest refers to the money a company pays toward a debt. Taxes (T) are tax obligations that a company must fulfill, depending on the regulations of where the business is located. Depreciation (D) and amortization (A) both indicate a reduction in the value of a company’s assets over its lifespan. However, the difference is that depreciation refers to the decrease in the value of tangible assets, while amortization is for intangible ones (e.g., patents).
How to calculate EBITDA
Now that you know EBITDA’s meaning, you might ask: How do you compute it? Two formulas are commonly used when computing EBITDA.Â
Formula 1:
EBITDA = Net income + Interest expenses + Taxes + Depreciation + Amortization
Formula 2:
EBITDA = Operating income + Depreciation + Amortization
When calculating EBITDA starting from net income, you look at what a company earns after all its business expenses have been removed. This includes everything from operational costs to interest, taxes, and more. On the other hand, when using operating income as the starting point for calculating EBITDA, the focus is on the company’s profit after just the operational costs have been deducted.
For example, you want to determine a business’ EBITDA. Looking at its income statement, you obtain the following figures:
- Net income: AED500,000
- Interest expenses: AED10,000
- Taxes: AED5,000
- Depreciation: AED20,000
- Amortization: AED10,000
To calculate its EBITDA, plug the above-stated figures in the first formula. It will look like this: EBITDA = 500,000 + 10,000 + 5,000 + 20,000 + 10,000. Upon computation, the answer you’ll get is AED545,000.
Read: How to calculate Return on Investment (ROI)
What is the EBITDA margin?
The EBITDA margin shows a company’s operating profit as a percentage of its revenue. You can calculate this using this formula: EBITDA margin = (EBITDA ÷ Total revenue) x 100. Generally, a good EBITDA margin is 10 percent.
If the total revenue is AED2 million, considering the EBITDA above, the equation will look like this: EBITDA margin = (545,000 ÷ 2 million) x 100. The answer to this is 27.25 percent.
Many financial analysts and investors use EBITDA margin to compare the core performance of companies in the same industry. Zeroing in on the operating profitability and cash flow will make it easier to see how a company is doing compared to others.
The different uses of EBITDA
EBITDA is a rather versatile tool in financial analysis. You can use it in various ways and gain more insights into a company’s performance. Here are some of its uses.
Assessment of overall performance
Advocates argue that EBITDA is a metric that provides a more equitable perspective on a company’s operational success. For instance, if you’re looking at a tech startup (an entity with typically hefty upfront costs, usually for software development), computing its EBITDA will let you see its potential for long-term growth. It’s because you’re calculating its core profitability and excluding substantial expenses.
Benchmarking against peers
As stated above, if you have EBITDA, you can get the EBITDA margin, which you can use to compare the financial health of companies, especially those within the same industry. It helps normalize performance metrics across businesses — notwithstanding size or financial structure.Â
Evaluation of debt service capability
This use of EBITDA is particularly helpful among those in the banking space. Analysts and lenders usually use this metric to compute the debt service coverage ratio (DSCR). DSCR refers to one’s capacity to manage and settle debts. Before lending money to a business, determining if a borrower has sufficient cash flow to cover obligations is essential.
EBITDA’s limitations
Like any other performance metric, EBITDA has its own disadvantages. For instance, it’s not recognized under Generally Accepted Accounting Principles (GAAP). GAAP is the standard framework for financial reporting. The implication is that EBITDA may not be the most reliable metric if you conduct a formal financial analysis.Â
Moreover, it doesn’t give the whole picture regarding a company’s financial health. For instance, it doesn’t take into account liquidity. If a company has liquidity issues, a positive EBITDA doesn’t necessarily mean it’s in good financial standing.Â
Additionally, EBITDA is susceptible to manipulation and misleading calculations. While it can strip out certain costs to highlight operational earnings, this adjustment might hide critical financial issues like high debt levels, rising expenses or actual unprofitability. Meanwhile, altering depreciation schedules can exaggerate profit projections, distorting a company’s financial status.
Final thoughts
After learning EBITDA, its meaning and various purposes, you’ll now understand why it’s a widely used metric when assessing a business’s operational efficiency and profitability. However, like other metrics, EBITDA has its own limitations. You must not fully rely on it to determine an entity’s financial health. Use it — along with other relevant measures of profitability and growth — to gain a better, more comprehensive understanding.
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