What Is EBITDA?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s used to measure a company’s operating performance and cash flow, without factoring in financing decisions, accounting decisions, or tax rates.
The world of small business accounting is filled with acronyms, and you might have heard this term before.
Your company’s EBITDA is a key indicator of the financial health of your business. Having a high EBITDA margin signals to investors, lenders, and customers that you have a high baseline profitability and can afford to pay off your business’s debts.
Starting with this metric, there are many related calculations you can make for your business. Find out what calculations are important for your business and what they can reveal.
Definition: What Does EBITDA Stand For?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s a way to measure your business’s income without it being impacted by financing decisions, accounting decisions, or tax rates.
Here’s what all the terms in this acronym mean:
- Earnings – You’ve probably got this one. It refers to the amount of profit you make in a specific period of time—usually a quarter or a full year.
- Interest – This is any interest payment you make on existing business loans or lines of credit. In some cases, you might receive interest payments from investments, so “interest” could refer to the net figure: interest income – interest expense.
- Taxes – What you’re required to pay in income taxes, payroll taxes, and sales taxes. Small business taxes are regulated at the federal, state, and local levels.
- Depreciation – Depreciation is relevant for “tangible assets,” which have a physical form—like your office building or any equipment you use. Over time, any tangible assets will depreciate in quality, meaning that they lose value. (A car that’s 10 years old is usually worth less than a car that’s only two years old, for example.) Depreciation takes into account the diminishing value of your tangible assets, so every accounting year a little bit of the cost of that car would be added into your accounting statements.
- Amortization – Amortization, on the other hand, is for “intangible assets” like patents or copyrights. Aside from that, it’s pretty much the same as depreciation: a little bit of the cost of the asset will be added to your accounting statements for as long as that asset continues to be usable.
Putting all of these together, EBITDA is a way to measure your earnings without taking the costs of interest, tax, depreciation, or amortization into account. Since different companies often make different financing decisions and exist in different tax environments, this measurement is a good way to compare the financial performance of two companies on an apples-to-apples basis.
EBITDA is usually calculated over a period of the last 12 months, which is why you’ll often read about LTM (last twelve months) EBITDA.
How Does EBITDA Differ From Other Measurements of Income?
Here’s how this measurement differs from other measurements of income that you might see on a profit and loss statement or other financial statements.
- Revenue – This refers to all of the money your company pulls in through sales. It’s also known as gross income. It’ll be at the top of your profit and loss statement and all the other figures will be calculated from your revenue.
- EBIT / Operating Income – EBIT is like EBITDA, but depreciation and amortization are accounted for with EBIT. EBIT only removes expenses related to interest and taxes.
- Net Income – This appears at the bottom of your income statement and is the result of subtracting all business expenses (including interest, taxes, depreciation, and amortization) from total revenue.
- Cash Flow – Cash flow is an analysis of the amount of money coming into your business versus the amount of money going out. This might sound the same as profitability, but it’s actually not. Because of timing problems with sales and accounts receivable, you can be profitable without being cash flow positive. (And likewise, you can be cash flow positive without showing a profit on your tax returns—if you’re trying to save on business taxes.)
You can use one of two formulas to calculate EBITDA:
- EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization; Or
- EBITDA = EBIT + Depreciation + Amortization
Whichever formula you use, you should have all the information you need to calculate EBITDA on your profit and loss statement. This makes it all the more important that your profit and loss numbers are accurate. Try generating your financial statements from QuickBooks or other accounting software, or seek help from a bookkeeper or accountant.
What Makes a Good EBITDA?
Basically, this formula allows you to measure your business’s profit while taking some things into account (like revenue and operating expenses) and not other things (tax, interest, depreciation, and amortization). It will give lenders a slightly different picture of your business’s finances than your operating income, your net income, or your cash flow.
But, how do you know if you have a good EBITDA or not? There are two ways to find out–by calculating your EBITDA margin and your EBITDA coverage ratio. Let’s dig into both in more detail.
The formula for EBITDA margin is as follows:
EBITDA Margin = EBITDA / Total Revenue
EBITDA margin determines what percentage EBITDA is of your overall revenue. What constitutes a “good” margin will depend on your industry, but in general, a higher EBITDA is better than a lower one. A high margin shows that you have a lot of revenue left over after covering your operating expenses.
For example, let’s say company A has an EBITDA of $100,000 and total revenue of $1 million. Now, let’s say company B has an EBITDA of $200,000 and total revenue of $2.5 million. Even though company B has higher EBITDA and higher revenues, its EBITDA margin is lower (8% compared to 10% for company A).
EBITDA Coverage Ratio
The formula for EBITDA coverage ratio is:
(EBITDA + Lease Payments) / Principal Payments + Interest Payments + Lease payments)
The coverage ratio compares your EBITDA to your company’s liabilities—your debt and your lease payments. The goal is to see whether you can afford to make your payments, given your profitability.
If the ratio is 1, then you’ll be able to pay off your debts, but just barely. A higher ratio means that you have more money and less debt.
Let’s try an example to see how all of these formulas actually work together.
Pretend that you run a small homemade pie shop called Slices of Heaven. You’re looking over your financial statements for the year—and you have your income statement and your balance sheet in front of you, thanks to your stellar accountant.
Here’s how you calculate EBITDA, EBITDA margin, and coverage ratio:
Total revenue: $1 million
Net income: $100,000
Interest expense: $10,000
Operating profit: $65,000
Lease payments: $50,000
Principal repayment: $30,000
First off, your EBIT is the same as your operating profit, but you can also calculate it by subtracting interest and tax from net income:
$100,000 / ($10,000 + $25,000) = $65,000
To get EBITDA, you need to add back in depreciation and amortization:
$65,000 + $10,000 + $5,000 = $80,000
For EBITDA margin, you must divide EBITDA by total revenue:
$80,000 / $1 million = 8%
Finally, for EBITDA coverage ratio, remember that
(EBITDA + Lease payments) / (Interest Payments + Principal Payments + Lease Payments)
Plugging the numbers in, that becomes:
($80,000 + $50,000) / ($10,000 + $30,000 + $50,000) = $130,000 / $90,000 = 1.44
With a coverage ratio of 1.44, you’ll be able to pay off your debts, but you don’t have too significant of a cushion to fall back on.
If your net income were $150,000 instead of $100,000 (let’s keep the taxes the same just for the sake of simplicity, even though in real life they would then be higher), your EBITDA coverage ratio would be much better. So, your business should aim to cut costs or increase revenue in order to generate a higher net income.
Bottom Line: Why Is EBITDA Important?
If you’re keeping your business records and financial statements up to date, you can use the EBITDA formula to gain insight into your business’s operating performance and the ability to meet your company’s obligations.
Being aware of this metric will help you better understand your baseline profitability and what kinds of debt you can handle—and whether or not you’ll be successful in taking on more.