EBITDA (earnings before interest, taxes, depreciation, and amortization) is often used as an alternative to net income to measure a company’s profitability. By eliminating the effects of financing and accounting decisions, EBITDA is designed to zero in on a firm’s operating performance without the impact of its capital structure.
Here’s a closer look at EBITDA, including how it works, how it’s calculated, and what this performance metric can tell you (and others) about your business.
Key Points
• EBITDA is a financial metric used to assess a company’s operating performance by adding back interest, taxes, depreciation, and amortization to net income.
• There are two formulas for calculating EBITDA: one starts with net income, the other starts with operating income.
• EBITDA helps compare profitability among companies by eliminating the impact of non-operating management decisions.
• Lenders often compare EBITDA to the loan payment to make sure a business is generating sufficient cash flow to make payments on financing.
• Another similar benchmark is EBITDA margin, which reveals how much cash is generated for every dollar of revenue earned.
What Is EBITDA?
EBITDA is an earnings metric that is commonly used to measure a company’s financial health and ability to generate cash. The formula takes net income then adds back certain expenses — interest on debt, tax payments, and noncash depreciation/amortization costs — to better assess a firm’s operating performance.
EBITDA isn’t recognized by the Generally Accepted Accounting Principles (GAAP) and typically doesn’t appear on the income statement. However, proponents of this metric believe it presents a clean picture of a company’s core profit by stripping away extraneous factors that can vary depending on a company’s capital structure and location.
What Is It Used for?
Business owners will often calculate EBITDA on a monthly or quarterly basis to see how their company’s raw earnings change over time.
Investors frequently use EBITDA to compare a company’s performance to its competitors. Unlike net income, this metric enables investors to look at companies based solely on their operations, excluding the impact of taxes, amounts of debt, and the cost of their capital investments. This allows for a more apples-to-apples comparison.
If you’re in the market for small business financing, a lender may look closely at your company’s EBITDA, since it represents the cash flow generated by the business that is available to make loan payments. Generally, a firm with a strong history of consistent and growing EBITDA will find it easier to get a business loan at favorable rates and terms.
EBITDA Formula
There are two EBITDA calculation formulas — one uses net income as the starting point, while the other uses operating income as the starting point.
Net Income
The formula for calculating EBITDA using net income is:
EBITDA = Net Income + Taxes + Interest Expenses + Depreciation & Amortization
Net income is calculated by subtracting all expenses from total revenue. This includes everything from the cost of goods sold (COGS) to interest and tax payments. In order to calculate EBITDA, you need to add back business loan interest and tax line items. In addition, you need to add back depreciation and amortization expenses.
Operating Income
The formula for calculating EBITDA using operating income is:
EBITDA = Operating Income + Depreciation & Amortization
Operating income is, as the name suggests, the money a business makes from its operations. It’s the amount of money that remains after operating expenses and COGS have been deducted from total revenue.
Operating income, or profit, is found in the middle of the income statement. Tax and interest expenses are already excluded, so you just need to add back depreciation and amortization.
The two EBITDA calculations can potentially yield different results as net income includes line items that might not be included in operating income, such as non-operating income or one-time expenses.
Breaking Down the EBITDA Formula
Here’s a more in-depth look at each part of the EBITDA calculation and why it’s included in the above formulas.
Net Income
Net income is profit as opposed to revenue. Also known as net profit, it’s the amount of money a company makes over a period of time after it accounts for all of its expenses incurred over that same period. It is the “bottom line” on the income statement and shows what’s left after subtracting all expenses from total revenue, including COGS, operating expenses, non-operating expenses, taxes, interest, and all other expenses.
Interest
Interest expense is the cost of borrowing money for business activities, such as taking out various types of business loans. Because how a business raises capital can vary widely, interest payments can differ significantly from company to company. Variations in how a company chooses to finance its activities (known as its capital structure) makes comparing business operations difficult. For that reason, interest is removed from consideration here.
Taxes
Taxes for EBITDA are the taxes paid by businesses, including income taxes, excise taxes, and employment taxes. Each locality has different tax laws, which means that tax payments can vary from one company to another. Since tax obligations aren’t uniform, they’re taken out of consideration in the EBITDA calculation.
Depreciation
Depreciation is the process of spreading out the cost of a tangible asset over the course of its useful life. While depreciation does cost a business money (as machinery and vehicles do wear out), it’s a non-cash expense that depends on past investments the company has made and not on the current operating performance of the business. Therefore, EBITDA doesn’t factor it in.
Amortization
The key difference between depreciation vs. amortization is that amortization involves the depreciation of intangible items, such as patents or licenses, which also have a limited useful life due to expiration. While amortization is an expense that is reported on a company’s financial statements, it isn’t directly related to a business’s core operations, so EBITDA doesn’t factor it in.
Operating Profit
Operating profit — also called operating income — is the result of subtracting a company’s operating expenses from gross profit. A business’s operating expenses are costs incurred from normal operating activities and include items such as office supplies and utilities. It does not consider interest or tax expenses but does include the non-cash charges of depreciation and amortization, so those must be added back to arrive at EBITDA.
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Example of the EBITDA Calculation
Let’s use fictional company ABC as an example of the EBITDA calculation. ABC has a net income of $10 million in a year. Also on the income statement are the following items:
Interest expense: $500,000
Tax expense: $1,000,000
Depreciation & amortization expenses: $400,000
To find EBITDA using the net income formula, you simply add interest, taxes, and depreciation & amortization expenses back to net income:
EBITDA = $10,000,000 + $500,000 + $1,000,000 + $400,000
EBITDA = $11,900,000
While ABC’s net income is just $10 million, EBITDA is higher after adding back those costs.
EBITDA Margin
EBITDA margin measures a company’s earnings before interest, tax, depreciation, and amortization as a percentage of the company’s total revenue. As a result, it can tell you what percentage of each dollar earned in revenue is making its way into EBITDA.
Generally, the higher the EBITDA margin, the less risky a company is considered financially.
The formula for calculating EBITDA margin is:
EBITDA Margin = EBITDA / Total Revenue
Like the EBITDA number, EBITDA margin can be used to compare a company’s financial performance to that of others within the same industry.
Recommended: Revenue vs EBITDA Explained
The Takeaway
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. This earnings metric is often used in place of net income to analyze and compare profitability among companies, as it eliminates the effects of financing and accounting decisions. Like all performance indicators, EBITDA is generally best calculated in tandem with other metrics that help business owners, investors, and lenders understand the whole picture of a business’s health.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What is the formula for calculating EBITDA?
EBITDA (earnings before interest, taxes, depreciation, and amortization) can be calculated in one of two ways:
Method #1: EBITDA = Net Income + Interest Expense + Taxes + Depreciation & Amortization
Method #2: EBITDA = Operating Income + Depreciation & Amortization
What would be considered a good EBITDA?
A “good” EBITDA (earnings before interest, taxes, depreciation, and amortization) will depend on the company and the industry. EBITDA alone does not reveal how profitable a company is. To learn from a firm’s EBITDA number, you’ll want to compare a company’s EBITDA over various periods or to a competitor’s EBITDA.
What taxes does the EBITDA calculation include?
Taxes included in EBITDA (earnings before interest, taxes, depreciation, and amortization) are all taxes paid by businesses, including income taxes, excise taxes, and the company’s share of employment taxes.
Photo credit: iStock/Nastassia Samal
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