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NOPAT and EBITDA are important business valuation methods, and understanding when to use NOPAT vs.EBITDA is key to grasping the finer details of a company’s financials.

NOPAT, meaning net operating profit after tax, is the amount of money a business makes from its day-to-day operations after taxes. Because analysts start with a company’s operating income, both cost of goods sold and operating expenses are important variables that contribute to the calculation of a company’s NOPAT.

EBITDA (earnings before interest, taxes, depreciation, and amortization) also zeroes in on a firm’s operational efficiency, but it does so by adding interest expenses, tax payments, and depreciation/amortization expenses back to net income. By doing this, it removes the effects of certain variables that can cloud a company’s financial performance.

Read on for a closer look at EBITDA vs. NOPAT, how these valuations are calculated, and how they compare.

NOPAT: Definition and Importance

NOPAT, which stands for net operating profit after tax, is a performance metric that tells you what a company’s income from operations would be if it had no debt (i.e., no interest expenses from small business loans or related tax write-offs).

By eliminating interest — and, thus, the impact of a company’s capital structure — NOPAT makes it easier to compare two companies in the same industry, even if one is much more highly leveraged than the other. NOPAT can also be used to compare a company’s performance from one year to the next.

NOPAT also doesn’t include one-time losses or charges, which can temporarily skew a company’s bottom line.

NOPAT is often considered one of the more realistic performance metrics because it includes many expenses that others don’t (most notably depreciation and amortization).

NOPAT Formula

The formula for NOPAT is as follows:

NOPAT = Operating Income X (1 – Tax Rate)

To use the NOPAT formula, you need to know the operating income (also called operating profit). This is the amount of profit a company makes after the cost of goods sold (COGS) and operating expenses (OPEX) are taken into account.

To determine a company’s operating income, subtract operating expenses from gross profits:

Operating Income = Gross Profit – Operating Expenses

The formula to calculate gross profit is:

Gross Profit = Revenue – Cost of Goods Sold

Here’s a further breakdown of each variable you’ll need:

•   Revenue: Revenue is the total sales generated by services and/or the sale of goods. It is how much money a company brought in.

•   Cost of Goods Sold (COGS): COGS is all direct costs associated with the production of goods or services. Common expenses associated with COGS include:

◦   Factory labor

◦   Freight costs for obtaining materials

◦   Parts used during manufacturing/ production

◦   Raw materials

◦   Storage

◦   Wholesale price of goods

•   Operating expenses (OPEX): All costs associated with the day-to-day running of a company. Common operating expenses include:

◦   Advertising

◦   Non-production equipment

◦   Depreciation of non-production assets

◦   Insurance

◦   Maintenance

◦   Marketing

◦   Office supplies

◦   Payroll

◦   Property taxes

◦   Rent

◦   Repairs

◦   R&D

Recommended: Net Operating Income vs EBITDA

How to Use NOPAT in Financial Analysis

NOPAT measures a company’s financial performance without taking into consideration its capital structure — meaning as if it were unleveraged and had no debt. By doing this, financial analysts can more easily compare two companies operating within the same industry.

To assess a business’s performance, analysts can look at a company’s sales (the “top line”), but sales alone don’t give any insight into operating efficiency. A company can have great sales and still go out of business if it has high operating expenses or COGS.

You can go the opposite route and just look at the “bottom line,” or net income. This figure includes operating expenses. However, it also includes tax write-offs like interest on debt, which can cloud understanding of a company’s performance.

NOPAT is effectively somewhere in the middle. It doesn’t just look at sales, and it removes the influence of leverage to offer a more accurate picture of operating efficiency. Think of it as a hybrid of total sales and net income.

Calculating NOPAT

To calculate NOPAT, analysts and investors need access to a company’s income statement (because operating income is a direct line item on the income statement).

The effective tax rate is the percentage amount needed for taxes, so the remainder (1 – the effective tax rate) is the amount left after allowing for taxes. So, for example, if a company’s effective tax rate is 30%, the net operating profit after tax would be 70% of the company’s operating profit. (or 1 – .30).

What NOPAT Tells You

NOPAT shows you a firm’s after-tax profits from its day-to-day business operations. As a result, it tells you what a company’s profitability would be if it did not receive tax benefits from holding debt. It also highlights how well a company uses assets to generate profits from core operations.

Analysts use NOPAT to compare a company’s current business performance to that of past years and to assess how a company is performing against its competitors.

Recommended: Small Business Line of Credit

Common Mistakes When Using NOPAT

There are many metrics used to evaluate a company, and not fully understanding the differences among them can lead to errors, especially if you use only one, rather than several, in your evaluation. What NOPAT is used for should, ideally, be to compare the performance of businesses in the same industry or to view how a company is progressing over time. But even then, misunderstandings and errors can occur. These can include:

•   Comparing companies without taking into account their different stages of growth. Where a company is in its growth trajectory affects its finances and operations, so even within an industry, a NOPAT-to-NOPAT comparison may not be as informative if the businesses are at different stages.

•   Since NOPAT doesn’t take capital structure into account, comparing companies with very different capital structures may be misleading.

•   NOPAT deducts capital expenditures, so if a company has spent a great deal on long-term assets, NOPAT may not accurately reflect its cash flow.

•   NOPAT doesn’t look at changes in working capital accounts, such as inventory, accounts receivable, and accounts payable, which can lead to an inaccurate picture of cash flow.

Understanding EBITDA and Its Role in Financial Metrics

EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It’s a metric often used by investors, analysts, and sometimes companies to measure a firm’s operational profitability because it excludes effects caused by capital expenditure decisions (that result in non-cash charges like depreciation and amortization) and financing choices (which are reflected in interest payments).

A lender might also consider your EBITDA when you apply for a small business loan (along with your credit scores, revenues, and other metrics) to get a fuller picture of your company’s financial health.

To truly understand EBITDA, as well as how to calculate EBITDA, it helps to understand the mindset behind removing the expenses listed in its name. Here’s a closer look.

•   Interest: This refers to interest paid on debt, including various types of small business loans. EBITDA doesn’t include this because the amount of debt a company carries will vary depending on the company’s financing structure. Some companies are more leveraged than others and, as a result, have widely different interest expenses. To better compare the relative performance of different companies, EBITDA adds interest paid on debt back to net income.

•   Taxes: A company’s tax burden is based on its structure, total revenue, and location. Therefore, two companies with the same amount in sales could pay very different amounts in taxes.

•   Depreciation: Depreciation allows a company to spread out the cost of a physical asset over the course of its useful life (minus any salvage value). While depreciation is a very real cost, it can vary significantly from one firm to the next, depending on the historical investments the company has made. Since this does not reflect a company’s current operating performance, EBITDA leaves it out of the equation.

•   Amortization: Similar to depreciation, amortization is the process of spreading out the cost of intangible assets, such as patents, copyrights, and trademarks, over their useful life. Some companies have more costs associated with intangible assets than others. Once again, the mindset is that regardless of what those costs are, they don’t reflect a company’s operational efficiency.

In addition to EBITDA, there is also adjusted EBITDA, which removes non-recurring, irregular, and one-time items that may distort EBITDA. This can help level the playing field even more.

Recommended: Comparing Amortization and Depreciation

Comparing NOPAT vs. EBITDA

So the question at this point is: NOPAT vs EBITDA, which is better? The answer depends on what you’re looking for. Here’s a look at their similarities and differences.

Similarities

•   Both EBITDA and NOPAT are used to calculate the financial strength of a company.

•   Interest from loans is not considered for both EBITDA and NOPAT.

•   Both place value on a company’s profits from its core areas of business.

Differences

•   NOPAT is after taxes, whereas EBITDA is prior to tax payments.

•   EBITDA also includes other non-operating income.

•   NOPAT accounts for depreciation and amortization charges, while EBITDA adds them back.

Here’s a side-by-side comparison of EBITDA vs NOPAT:

Recommended: EBITDA vs. Gross Profit

When to Use Each Metric

It can be challenging to know whether it’s more appropriate to use NOPAT or EBITDA. Here are some general guidelines.

EBITDA may be the better metric when:

•   You want a quick take on how much money a company is generating from its core operations.

•   You’re comparing companies with different operational structures.

•   You need to compare companies that have different asset bases and don’t want to take amortization and depreciation into account.

NOPAT may be more useful wen:

•   You’re looking for a snapshot of how well a company is doing operationally.

•   You’re planning your business’s strategy and want to track your operations.

•   You want to compare companies with different capital structures and/or amounts of debt.

Advantages and Limitations of NOPAT

Here are the advantages and disadvantages of using NOPAT in chart form:

Recommended: Startup Business Loans

How NOPAT Differs from Unlevered Free Cash Flow

Unlevered free cash flow (also known as free cash flow or UFCF) is a theoretical cash flow figure for a business. It measures how much cash a company would have after all operating expenses, capital expenditures, and investments in working capital have been made.

UFCF can be calculated using either NOPAT or EBITDA:

NOPAT − Net Investment in Operating Capital = Free Cash Flow

OR

EBITDA – Capital Expenditures – Changes in Working Capital – Taxes = Free Cash Flow

Capital expenditures typically include any investments a company has made in tangible assets like machinery, buildings, or any type of heavy equipment.

Working capital includes such items as the cost of inventory, accounts payable, and accounts receivable.

NOPAT, by contrast, does not take into account changes in net working capital accounts (such as accounts receivable, accounts payable, and inventory). As a result, a company’s NOPAT will be different from its unlevered free cash flow.

Recommended: EBITDA Margin

Real-World Example of NOPAT Calculation

Cheryl’s Chocolate, a fictional high-end chocolate store, had a total revenue of $800,000 for the previous year. Its COGS was $250,000, and it spent $150,000 in operating expenses. It had an operating income of $400,000 ($800,000 – $250,000 – $150,000 = $400,000).

Cheryl’s Chocolate has a tax rate of 30%.

NOPAT = Operating income x (1- tax rate)

NOPAT = $400,000 X (1- 0.3)

NOPAT = $400,000 X (0.7)

NOPAT= $280,000

Recommended: What Is EBITDAR?

How NOPAT Fits Into Broader Valuation Models

NOPAT is a key metric used in many valuation models and related metrics. Here are some common examples.

Discounted Cash Flow (DCF) Analysis. This method values a company by predicting its future cash flow. It relies on NOPAT to determine UFCF and future cash flow.

Return on Invested Capital (ROIC). This metric gauges how well a company is using its capital. Its calculation uses NOPAT as the numerator, which is divided by invested capital to arrive at ROIC.

Economic Value Added (EVA). This metric helps you assess the true profit a company’s making if you consider the cost of all the capital it uses. NOPAT is a necessary part of determining this metric as well.

Recommended: 22 Small Business Tax Deductions

The Takeaway

Both EBITDA and NOPAT are useful performance metrics. NOPAT represents a company’s operating income after taxes and doesn’t account for interest expenses. EBITDA also shows a business’s earnings before interest, but also adds back non-cash charges like depreciation and amortization.

Both NOPAT and EBITDA can be used to track a company’s performance year over year as well as compare companies within the same industry. Some analysts prefer NOPAT to EBITDA because it takes more expenses into account.

Understanding these corporate metrics can be valuable as you make key decisions about expenses and funding, such as business loans.

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

How can you convert EBITDA to NOPAT?

To convert EBITDA to NOPAT, you would first convert EBITDA (earnings before interest, taxes, depreciation, and amortization) into EBIT (earnings before interest and taxes) by backing out depreciation and amortization from the EBITDA number. Next, you would use this formula to calculate NOPAT (net operating profit after tax), using the formula NOPAT = EBIT x (1 – Tax rate).

Is NOPAT the same thing as net income?

No, net income is calculated by deducting all the expenses incurred during the year from total revenue. NOPAT, meaning net operating profit after tax, on the other hand, is calculated using just a company’s operating income, which is the amount of profit realized only from a business’s operations.

What makes NOPAT a better performance measure than net income?

Unlike net income, NOPAT (net operating profit after tax) considers what a company’s income from operations would be if it had no debt or interest expense. As a result, it can be more useful than net income for comparing two companies in the same industry that may have different capital structures (such as one that is highly leveraged and one with no debt).

How does NOPAT impact company valuation?

NOPAT impacts company valuation by providing a clearer picture of a company’s profitability without the influence of debt financing. It helps investors assess operational efficiency and cash flow potential, which are critical for valuation models like discounted cash flow (DCF) and enterprise value calculations.

Why do analysts prefer NOPAT over EBITDA in certain cases?

Analysts prefer NOPAT over EBITDA in certain cases because NOPAT accounts for taxes and provides a clearer picture of a company’s true operating profitability. Unlike EBITDA, which excludes interest and taxes, NOPAT reflects the actual after-tax earnings from operations, making it more useful for comparing companies with different capital structures.

Photo credit: iStock/tdub303

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SOSMB-Q425-025

If you’ve been denied a personal loan recently or don’t think a personal loan is right for you, you might feel at a loss as to how to cover a large expense or fund a major project.

The good news is, there’s no shortage of personal loan alternatives that suit a variety of situations. Here’s what you need to know.

Credit Card

A credit card offers you a line of credit that can be used for a variety of purchases and could be a loan alternative. You can borrow up to a set credit limit, and each month that you carry a balance, you’ll owe at least the minimum payment. Credit cards are generally seen as a better option for smaller, everyday purchases, while a personal loan may make more sense for larger, more expensive items, such as a house or car.

Using a credit card responsibly can be a good way to establish your credit history, so long as you make timely payments each month. And some cards may come with perks, such as rewards points or travel rewards.

On the downside, if you don’t pay off the full balance of your credit card each month when it’s due, then your balance will accrue interest. (And credit cards typically have higher interest rates than personal loans.) If you continue to make charges on the credit card while only making minimum monthly payments, then it will take you even longer to pay off the balance. To find out how much interest you’ll pay on any balance, you can use a credit card interest calculator.

Applying for one credit card can ding your credit score by just a few points. But applying for multiple cards at once could raise red flags for lenders and can drag down your credit score.

Here’s a summary of the pros and cons of this alternative:

Pros

•   Can tap into funds as needed and repay as you go

•   Can build credit as long as you make on-time payments

•   Some cards come with perks such as rewards points and travel-related benefits

Cons

•   Can have higher interest rates than personal loans

•   May take you longer to pay off the balance if you only make the minimum payments

•   Applying for too many cards at once may hurt your credit

Recommended: Personal Loan vs. Credit Card

Personal Line of Credit

A personal line of credit is a type of revolving credit line that can be used for many different things. Like credit cards, a personal line of credit has a maximum credit limit, and borrowers are required to make a minimum monthly payment. Once the debt is repaid, money can be withdrawn once again. Personal lines of credit may be secured, which require collateral, or unsecured, which do not require collateral.

When comparing a personal line of credit vs. a personal loan, you may discover that a personal line of credit allows you to access money over time instead of all at once. This level of flexibility may reduce interest charges, because you’re only taking out the money you plan on using right away. And generally speaking, the interest rates on a personal line of credit tend to be lower than those on a credit card.

However, it can be difficult to qualify for an unsecured line of credit with a good interest rate, as they’re more risky for the lender. Plus, the flexibility of a line of credit could make it easy for borrowers to take on more debt or take longer to pay off what they owe.

Pros

•   Typically has a lower interest rate than credit cards

•   Funds can be used for a variety of purposes

•   You can access funds as you need them

Cons

•   May be difficult to qualify for an unsecured line of credit with a good interest rate

•   Can be easy to take on more debt or take longer to pay off the balance

Recommended: Should You Pay Off Debt or Save First?

Home Equity Loan

If you’re a homeowner and meet certain requirements, you may have the option to take out a home equity loan, which is a different kind of debt than a personal loan. This means you’re essentially borrowing against the equity you’ve built in your home.

Like a personal loan, funds from a home equity loan are disbursed in one lump sum, and you owe monthly payments for the life of the loan. Your home secures the loan, and because of that, lenders tend to offer a lower interest rate than they would on most unsecured loans. Interest rates are usually fixed.

It’s worth noting that repayment begins right away, and if you fall behind on your payments, you risk losing your home. In addition, the loan amount is set, so if you need more money, you’ll need to apply for another loan.

Pros

•   Low interest rate

•   Can borrow large amounts of money

•   Funds can be used for a wide variety of purposes

Cons

•   Risk losing your home if you fall behind on payments

•   Repayment begins immediately

•   Loan amount is set

Like a home equity loan, a home equity line of credit (HELOC) is secured by the equity you’ve built in your home, and your home is used as collateral.

One of the main differences is that a HELOC offers a revolving line of credit, which means you can tap into funds as needed and only pay interest on what you borrow. There are usually low or no closing costs involved with a HELOC, and the interest rate is likely to be variable.

There are some potential drawbacks to keep in mind when comparing HELOCs vs. personal lines of credit. For starters, you may have to pay closing costs on the loan amount, though some HELOCs come with low or zero fees. Your interest rate will likely change with the federal funds rate, which means that over time, your monthly payment amount may fluctuate. Also, if you fail to make payments and the loan goes into default, you risk losing your home.

Pros

•   Only borrow what you need

•   Lower initial interest rates than unsecured loans

•   Repayment terms can be flexible

Cons

•   Can lose your home if the loan goes into default

•   Variable interest rates

•   Can be upside-down on your mortgage (i.e., you owe more on your home than what it’s worth)

Retirement Loan

Also known as a 401(k) loan, a retirement loan is a type of loan where you borrow from your retirement account and pay yourself back over time with interest. You can typically borrow against a 401(k), 403(b), or 457(b) retirement plan.

Per IRS guidelines, you can borrow up to $50,000 or 50% of your account balance, whichever is less. Unless you’re putting the money toward buying your primary residence vs. using it to, say, pay off debt, you have five years to repay your loan and need to make quarterly payments.

It’s worth noting that you cannot borrow against an IRA.

Pros

•   Don’t have to go through a lengthy application process

•   Doesn’t impact your credit

•   Loan repayments are automatically taken out of your paycheck

Cons

•   Can’t borrow more than $50,000

•   Missing out on compound interest and growing your retirement funds

•   If you file for bankruptcy, you’re still on the hook for paying off the loans

Peer-to-Peer Loan

Also known as social lending or crowd lending, a peer-to-peer loan (P2P loan) is a financing model where individuals borrow from others through an online platform. In turn, the financial institution is cut out of the picture, and individuals can borrow from individual investors or lenders.

The main draw for lenders is that they might earn more on the interest than if they put their money in a savings account. Borrowers might be eligible for lower interest rates or less-strict lending criteria. What’s more, the funding process is often quicker than going through a bank — an application may be approved within minutes and funds disbursed within a few business days.

Pros

•   Flexibility in how funds can be used

•   Speedy funding process

•   May qualify with fair credit

Cons

•   Often have origination fees (up to 10% of the loan)

•   Might have a higher interest rate

•   Might have late fees

Salary Advance

If you have an urgent financial need or emergency, you might be able to get part of your future paycheck now as a personal loan alternative. In essence, it’s a loan from your employer, with the expectation that you’ll pay it back.

Your company might charge a fee or interest rate to cover the extra paperwork and accounting. However, it could be a solid way to pay for an emergency, provided you know the terms, restrictions, and what a salary advance entails.

Pros

•   Easy repayment methods (i.e., funds are automatically deducted from your paycheck)

•   Can provide easy, quick access to funds

•   Interest rates may be lower than other types of loans

Cons

•   Not offered by all employers

•   May need to meet eligibility requirements, such as a minimum number of years of employment and no previous paycheck advance requests

•   Might get complicated if you leave your job and haven’t repaid the advance

•   Smaller-than-usual paychecks could make it more difficult to make ends meet

Mortgage Refinance

A mortgage refinance is when you’re swapping your current mortgage for a new one and can be a personal loan alternative. There are different reasons why this route might be attractive for you, such as locking in a lower interest rate or a lower monthly payment. With a cash-out refinance, for example, you replace your existing mortgage with a new mortgage for more than the previous balance. You receive the difference in cash.

Pros

•   You can receive a tax break if funds are used for home improvements

•   Can have relatively lower interest rates than other types of financing

•   Can stretch out your repayment period

Cons

•   Can risk foreclosure if you aren’t able to keep up with payments

•   Will need to pay closing costs

Buy Now, Pay Later Services

If you are thinking about making a major purchase, like a new washer/dryer, a buy now, pay later (BNPL) service could be an alternative to a personal loan. These services (like Klarna and Affirm) typically allow you to make a purchase and finance it via a few interest-free payments over a short period of time.

Pros

•   Allows you to make a purchase, get the item, and pay it off over time

•   Often offers interest-free payments

•   Only requires a soft credit check or no credit check

•   Application and approval is typically quick and easy

Cons

•   Can lead to overspending

•   Missing a payment can lead to late fees

•   Late or missed payments can negatively impact your credit

Family or Friend Loan

If you are fortunate, you might have a relative or friend who’s potentially able to help lend you money when you need it. This kind of family or friend loan typically doesn’t require a credit check and can offer low-interest terms. Note that the IRS has guidelines for the interest rate to be charged for this kind of loan.

Pros

•   Family or friend loans can offer borrowers with no or low credit a way to access funds.

•   Typically, the repayment terms of family or friend loans can be flexible.

•   Interest rates can be low.

Pros

•   Family or friend loans can lack clear legal guidelines

•   Late or missed payments can negatively impact your relationship with the lender

•   No- or extremely low interest rates can conflict with IRS guidelines

•   Making timely payments to a friend or relative who’s loaned you money will not positively impact your credit score

Debt Consolidation Loan as Alternative

You may also find that a debt consolidation loan is an option. This is actually a specific type of personal loan, one that is tailored to help combine high-interest credit card debt into one loan that is easier to pay and may offer a lower interest rate.

Pros

•   Combines multiple debts into one loan, for a single monthly payment

•   May offer a lower interest rate vs. current debts

•   May help you pay off debt more effectively

Cons

•   May involve a longer repayment period and higher interest over the life of the loan

•   Fees may be assessed that can be challenging to pay

•   Must meet the lender’s qualifications to be approved for the loan

The Takeaway

There are pros and cons to personal loans, so if you decide to explore other funding options, rest assured there’s no shortage of personal loan alternatives. Examples run the gamut from home equity loans and HELOCs to personal lines of credit and credit cards.

By knowing what’s out there and weighing the advantages and disadvantages of each, you’ll stand a stronger chance of figuring out what is best suited for your needs.

Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. See your rate in minutes.

FAQ

What alternatives to personal loans are the most popular?

Among the most popular options for personal loans are credit cards, retirement loans, home equity loans, home equity lines of credit (HELOCs), peer-to-peer loans (P2P), and a cash-out refinance. Each option has its pros and cons and different lending requirements, and each may be better suited for specific borrowers.

Why would you need to use an alternative to a personal loan?

You might need a personal loan alternative if you don’t qualify for a traditional personal loan, or, if, after doing your research, you’ve found that it isn’t the best option for your needs.

Can you use personal loan alternatives even if you have a personal loan?

Yes, you can use personal loan alternatives if you currently have a personal loan, provided the lender approves your application. However, if you have multiple loans, it’s important to ensure you can keep up with the payments.

What is a good alternative to a personal loan for bad credit?

If you have poor credit, you might look into a friend or family loan, or consider making a purchase with a buy now, pay later service.

Are personal loan alternatives safer or riskier than personal loans?

Whether an option is safer or riskier than a personal loan depends on the particular alternative you are exploring and your situation. For instance, a HELOC puts your house at risk of foreclosure if you default. If you have a loan from a relative and don’t repay it on time, you could do serious damage to that relationship.

Photo credit: iStock/zamrznutitonovi

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SOPL-Q425-050

A small business can start with nothing but a great idea — but as that idea begins to coalesce into an actual operation, there are some key structural elements you’ll want to put in place. One thing you’re likely to need is a business bank account. The many advantages of a business bank account include simplifying bookkeeping and tax preparation, establishing credibility, accepting customer payments, and more.

What Is a Business Bank Account?

For convenience’s sake, it might be tempting to consider using a personal bank account vs. a business account for your new company. But convenience isn’t the whole story. It’s crucial for your new venture to have a business bank account before you start spending or accepting money.

A business bank account is used to manage financial transactions, such as receiving payments from customers, paying vendors, and paying employees. Commonly, business accounts include a business checking or savings account, a credit card account, and a merchant services account that enables you to accept credit and debit card transactions.

Key Benefits of a Business Bank Account

There are several solid reasons to open a business bank account. First, it helps you keep personal and business finances apart, which is important for legal and tax purposes. For example, separate accounts make it easier to track which expenses are business-only and thus could be possible tax write-offs.

A business bank account can also contribute to a professional image for your company. Customers pay the business directly rather than you, lending authority to your transactions.

Merchant services accounts support card transactions and offer customers purchase protection. This also helps ensure customer credit card information is safe.

What’s more, opening a business bank account along with company credit cards can help your business build credit and improve its access to future loans. Lenders will look for a strong credit history, including a track record of paying bills on time, when determining your creditworthiness.

Recommended: Startup Business Loans

Legal and Tax Benefits of a Business Checking Account

A business bank account can help you streamline your finances. You can easily view your account balances, income, recent payments, and perhaps the details of your business line of credit or other loans.

Keeping personal transactions clearly separate from business transactions will be useful later, when you’re preparing your business tax return. Personal expenses generally aren’t deductible as business expenses. Improper business deductions on your tax return might lead the IRS to charge you penalties and interest. In the worst case, IRS suspicions of fraud could turn into criminal charges.

A business bank account can also be a tool for shielding business owners’ personal assets. LLCs and corporations legally separate the business from the owner, so that in case of loss or legal damages, creditors can go after company assets only. Having a business bank account makes it clear which money belongs to the company.

Financial Management Advantages of a Business Bank Account

Many business bank accounts come with features that can help make financial management easier. For instance, as noted earlier, they may be linked to business credit cards that can help you make purchases and grow your business.

Other business checking account benefits might include invoicing tools and accounting software. You may have the ability to upload receipts and categorize spending. And you may be able to work with a dedicated account manager at your bank who provides a single point of contact, supporting your needs and advocating for you as necessary. (This relationship could also come in handy if or when you go shopping for a small business loan.)

Recommended: Equipment Financing

Types of Business Accounts

Common types of business bank accounts include:

•   Checking accounts: A deposit account that allows easy access to your money; critical for making and receiving payments. A business checking account allows for writing checks and the use of debit cards.

•   Savings accounts: A deposit account that typically earns interest, allowing you to set aside money for future goals or for an emergency fund.

•   Merchant accounts: A specialized account that allows you to accept credit and debit card payments. The account acts as an intermediary that holds funds from customer transactions before depositing them into your main account. (Many businesses use payment processors in lieu of merchant accounts. The processing system would send your payment to your business account.)

•   Credit accounts: Credit card and business lines of credit are forms of revolving credit. Credit cards allow you to borrow up to a certain limit. Ideally you’d pay back what you owe each month, but if not, you can carry a balance month to month. If you do carry a balance, you will owe interest on the debt. Similarly, lines of credit allow you to borrow up to a given limit. You’ll owe interest on the amount you borrow, and when you repay the debt, the money is available for you to borrow again.

How to Choose the Right Business Bank Account

Rates, fees, and features will vary from bank to bank. Shop around to find business account packages with the lowest fees and the right benefits for your situation. Some aspects to look at include interest rates on checking and savings accounts, as well as interest rates on credit cards and lines of credit. Take a look at transaction fees, early termination fees, and minimum account balance fees.

A merchant account may be an important feature, especially if you choose not to use a separate payment processor. When considering a merchant account, look closely at the per-transaction fee (the amount charged for processing every credit card swipe) and the monthly fee.

The Takeaway

Opening a business bank account is a crucial move for small businesses. Separating business banking from personal banking typically helps with financial management, simplifies tax preparation, and makes it easier for companies to build credit. For certain business structures, having separate business accounts can also help shield personal assets from legal damages.

If you’re seeking a checking account for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare checking account options for your business in minutes.

FAQ

Do I need a business bank account as a sole proprietor?

As a sole proprietor you are not legally required to have a business bank account. You could use a personal account for business purposes, but it’s not necessarily a good idea. Having a separate business account will help you sort out business and personal expenses and income, making it easier to produce financial statements and tax returns.

Can I use my personal bank account for business expenses?

Legally, you can use a personal bank account for your business only if you are a sole proprietor or a single-owner LLC. Otherwise, you must have a business bank account. Generally it is to your advantage to have at least one business account for any company you run, regardless of structure.

Does opening a business account help build business credit?

Opening a business account can help your company build credit, as it clearly indicates that your business is separate from you as an individual. Any loans or lines of credit for the enterprise can run through your business account. Paying those bills on time while minimizing debt should improve the company’s credit score, and a high credit score can help you access loans at lower rates.

What documents are required to open a business bank account?

To open a business bank account, you’ll need to have an employer identification number, or EIN, from the federal government (sole proprietors can simply use a Social Security number). You’ll be expected to produce ownership agreements and documents related to your business formation. You may also be required to show a business license.

Can I have multiple business bank accounts?

There’s no limit to the number of business accounts that you can have. Managing multiple accounts can be complex, but there may be tradeoffs that make it worthwhile. For example, you may be able to track certain kinds of transactions better by setting up designated accounts, such as separate accounts for payroll and incoming client payments.

Photo credit: iStock/Djordje Krstic

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

This content is provided for informational and educational purposes only and should not be construed as financial advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

This article is not intended to be legal advice. Please consult an attorney for advice.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

SOSMB-Q425-008

If you’re considering taking out a business loan, you’ll want to make sure your company looks like a safe bet in the eyes of a lender. One of the metrics they may review is your debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio.

Debt-to-EBITA is a financial metric that looks at how much of the income your business is generating is available to pay down debt before covering interest, taxes, depreciation, and amortization expenses.

Read on to learn how this ratio is calculated and how to know if your company’s debt-to-EBITDA ratio is healthy.

What Is Debt-to-EBITDA?

Simply put, debt-to-EBITDA measures the ability of your company to pay off its debts. It compares the business’s actual cash earnings to its financial obligations, including debt and other liabilities.

A high debt-to-EBITDA ratio might result in a lower business credit score, whereas a lower ratio could positively impact your credit profile, making it easier to qualify for financing at favorable rates and terms.

What Is EBITDA?

EBITDA stands for earnings before interest, tax, depreciation, and amortization. It is a measurement of a company’s profitability before those expenses are taken out.

While not accepted by GAAP (generally accepted accounting principles), EBITDA is often used by analysts and investors to compare the profitability of two companies in the same industry.

The reason for this is that EBITDA removes expenses that can vary depending on a company’s capital structure (and how much it spends on interest on debt), historical investments (which affect its depreciation and amortization expenses), and tax burden (which can vary from state to state).

You can calculate EBITDA by looking at your income statement and adding interest, tax, depreciation, and amortization back to net income.

EBITDA = Net Income + Interest + Taxes + Amortization + Depreciation

Recommended: What Is EBITDAR?

What Is Debt?

Debt is anything your company owes another company or individual and includes both short-term and long-term debt obligations. You can find these numbers in a company’s quarterly and annual financial statements.

Exactly what obligations are included in total debt for the debt-to-EBITDA ratio, however, is somewhat open to interpretation. Often, it’s defined as all interest-bearing liabilities, such as small business loans.

If you want to take on more debt, lenders may look at financial metrics like your debt-to-income ratio, debt-to-equity ratio, and debt-to-EBITDA ratio. All of these can help a lender understand the likelihood of your company being able to repay a new loan with the given amount of debt you currently have.

Formula for Calculating Debt-to-EBITDA

Calculating the debt-to-EBITDA ratio is done by dividing the sum of a company’s short-term debts and long-term debts by its EBITDA. The main goal of this ratio is to reflect the amount of cash available at the company to pay back its debts. (If you look at just the long-term debt, the result is called a funded debt-to-EBITDA ratio.)

Debt-to-EBITDA Ratio Formula

To calculate the debt-to-EBITDA ratio, you would use this formula:

Debt-to-EBITDA Ratio = Total Debt / EBITDA

What the Debt-to-EBITDA Ratio Tells You

The debt/EBITDA ratio compares a company’s total liabilities to the actual cash it is bringing in. The goal of this financial ratio is to show how capable the business is of paying its debt and other liabilities.

Generally, the lower your debt-to-EBITDA ratio, the more money your company has available to cover its financial obligations when they come due. A higher debt-to-EBITDA ratio, on the other hand, suggests that the business is heavily leveraged and might run into trouble paying its debts.

What’s considered a good debt-to-EBITDA ratio will vary by industry. Generally speaking, however, a ratio of 4 or 5 is considered to be high. This may be a red flag to potential investors or lenders that your business is overleveraged and could potentially default on its debts.

Recommended: What Is EBITDA Margin?

Why the Debt-to-EBITDA Ratio Matters to Lenders

Your company’s debt/EBITDA ratio can be an important factor to lenders when they are considering extending a loan to you. This metric is significant to potential lenders for several reasons.

Assessing Credit Risk

Before offering a loan to a potential borrower, lenders typically want to know that the borrower will be able to repay the loan. To gauge that ability, they may look at a variety of factors, including the owner’s credit history, the company’s credit score, and others. One of the key metrics is the company’s debt-to-EBITDA ratio since it shows how the company’s debt compares to its earnings, suggesting how much cash it may have available to repay new debt.

Evaluating a Company’s Financial Health

A company’s debt-to-EBITDA ratio also suggests how well the company is doing financially. That’s because it indicates whether the business is able to pay its debts with the income it’s making. Lenders may consider this metric in order to gauge a company’s financial health, based on the metric and the standard in its industry.

Recommended: What Is Debt Factoring?

Uses of Debt-to-EBITDA

So when would you actually use your debt-to EBITDA ratio? If you’re looking to borrow money for your business, it can be smart to calculate your debt-to-EBITDA ratio before you start the business loan application so you know where you stand.

If you borrow money from a bank, there may be a requirement to meet a certain debt-to-EBITDA ratio in your loan agreement. If you can’t maintain that ratio, you may risk the loan being called.

If you are considering bringing on investors, they may also want to look at your debt-to-EBITDA ratio. Investors will often use this ratio to gauge the approximate amount of time it will take a company to pay off all of its debts with its available cash.

Recommended: How to Read Financial Statements

How Different Industries Use the Debt-to-EBITDA Ratio

What is considered an acceptable debt-to-EBITDA ratio varies from industry to industry. For example, for utilities and telecoms, which have relatively predictable cash flow, a higher debt-to-EBITDA ratio may be considered acceptable. For technology and software companies, which can often grow quickly without incurring extensive debt, good debt-to-EBITDA ratios may be on the lower end. It’s important to understand what the expectation is in your industry when you want to apply for a loan so that you’ll understand how your company will be evaluated.

Recommended: What Is EBIDA?

Pros and Cons of Using the Debt-to-EBITDA Ratio

There are both benefits and drawbacks to using debt-to-EBITDA ratio to assess the financial health of a business. Here’s how they stack up.

Pros

Debt-to-EBITDA is simple to calculate. Debt can be found on the balance sheet and EBITDA can be calculated from the income statement. As a result, this ratio can be a quick way to get a snapshot of a company’s financial health and liquidity.

The debt-to-EBITDA ratio is also popular with analysts because it relates the debts of a company to its business cash flow by ignoring non-cash expenses. This is important because, in the end, it’s cash, and not profits, that is needed to pay off debts.

Cons

Because EBITDA adds interest, taxes, depreciation, and amortization to net income, it may not provide an accurate measure of a firm’s actual earnings. If any of these variables is high, it could impact a company’s ability to pay debts.

In addition, debt-to-EBITDA may not be useful for comparing companies in different industries. Capital requirements vary by industry and, as a result, some companies need to carry a higher debt loan than others. For this reason, using debt-to-EBITDA to compare firms across industries may not be reliable.

Debt-To-EBITDA Ratio Example

Let’s look at an illustration of how the total debt-to-EBITDA ratio can indicate a company’s financial health (or lack thereof).

Calculation Example

Let’s say company ABC’s EBITDA is $10 million and its debts add up to $30 million. To calculate ABC’s debt-to-EBITDA ratio, you would calculate:

Debt-to-EBITDA = $30 million / $10 million

Debt-to-EBITDA = 3

A debt-to-EBITDA ratio of 3 is generally considered low and indicates that ABC has revenue to cover its debts. A lender may look at that ratio and decide ABC isn’t a risk and approve a loan.

Here’s another example: Let’s say company XYZ has an EBITDA of $10 million, but has $60 million in debt. This would be its ratio:

Debt-to-EBITDA = $60 million / $10 million

Debt-to-EBITDA = 6

Depending on the industry, a ratio of 6 may be considered high and could make it difficult for XYZ to get a good credit rating and qualify for any additional financing.

How to Interpret the Results

It’s important to be careful as you interpret your debt-to-EBITDA ratio. What is considered a healthy ratio varies considerably by industry, so it’s helpful to have a sense of the benchmark in the one in which your company operates. As discussed in the examples above, the metric will be understood by lenders in the context of what good numbers look like for other, comparable companies.

Recommended: A Guide to Ecommerce Business Loans

The Takeaway

The debt-to-EBITDA ratio reveals how much actual cash a company has available to cover its debt. It is one of many financial metrics used by lenders, analysts, and investors to gauge a company’s liquidity and financial health.

As a business owner, it can be a good idea to calculate your company’s debt-to-EBITDA ratio periodically. It can give you insights into your company’s current financial position and also help you see trends over time. If you see the ratio going down, for example, it means that you are paying down debt, the company’s earnings are going up, or both.

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 considered a good debt-to-EBITDA?

A good debt-to-EBITDA ratio will depend on your industry. Generally, however, a ratio of three or less can indicate that your business has enough cash flow to comfortably cover its debts.

Is debt included in EBITDA?

Yes. EBITDA stands for earnings before interest, tax, depreciation, and amortization. Interest represents the interest your business is paying on its debts.

What does debt-to-EBITDA indicate?

The debt-to-EBITDA ratio indicates how much income your company has available to pay down debt before covering interest, taxes, depreciation, and amortization expenses.

How can a company improve its debt-to-EDITDA ratio?

To improve debt-to-EBITDA ratio, a company could pay down its debt, increase its earnings, or both.

What are the limitations of the debt-to-EBITDA ratio?

Debt-to-EBITDA ratio has certain limitations. If a company is paying a lot for any of the elements that EBITDA adds to net income — interest, tax, depreciation, and amortization — its ability to pay back debt may be less than the debt-to-EBITDA ratio suggests. Additionally, if you’re using debt-to-EBITDA ratio to compare companies in different industries, you won’t necessarily get a good result, since expectations of the ratio vary by industry.

Photo credit: iStock/sanjeri

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

SOSMB-Q425-014

If you own a small business, you likely have quite a few expenses associated with operating your company. Business credit cards can offer a way to manage and even take advantage of those business expenses, while building your credit.

What Is a Business Credit Card?

Business credit cards offer a way for a company to charge for business-related expenses. Business credit cards function similar to personal credit cards, but are specifically for businesses and their unique needs. Just like there are business checking account options and personal checking account options, there are also business and personal credit cards.

How Business Credit Cards Work

Business credit cards work similarly to personal credit cards by providing businesses with a line of credit for purchases. Just as with personal credit cards, a company will put charges on the business credit card and then pay the card’s balance.

Key Features That Differentiate Them From Personal Cards

When differentiating between personal credit vs business credit cards, there are some key differences. Business credit cards usually have higher credit limits. Issuers consider both personal income and business revenue when determining credit limits for business credit cards. Personal credit cards only consider personal income when determining credit limits.

Another difference is that business credit cards primarily report to business credit bureaus, which affects your business credit score. Personal credit cards usually report to consumer credit bureaus. However, business credit cards can impact your personal credit score because your personal credit score is part of business credit card applications. Also, business credit card issuers can report negative activity to consumer credit bureaus.

One thing to keep in mind is that business credit cards have fewer consumer protections. Business credit cards aren’t required to provide some of the consumer protections that personal credit cards have to.

Pros of Business Credit Cards

There are several pros of using business credit cards. One of the main reasons why business owners use business credit cards is to keep business expenses separate from personal expenses. A business credit card is an easy way to keep track of your business expenses, especially when it comes time for taxes. Combining personal and business expenses is not advised.

If you have a business, it is important to have a good business credit history if you need to apply for a loan or other business credit. Responsible usage of business credit cards can help in building business credit history and improving your business credit score.

Many business credit cards offer the chance to earn rewards and cash back. Depending on the card, you might earn rewards or cash back for business-related purchases, like shipping, office supplies, internet, or travel. Plus, credit card rewards are not considered income, so they are not taxable. Some business credit cards also offer additional benefits like purchase protection or extended warranty on qualifying items purchased with the card.

Cons of Business Credit Cards

Although there are many benefits to having a business card, there are also downsides. Like all credit cards, business credit cards may be tempting to overspend. If your business has financial hardship and can’t pay the credit card bills, it could actually negatively affect your personal credit.

Small business credit cards also usually have higher interest rates than personal credit cards or business loans like startup business loans. If you pay off your credit card balance, however, then it won’t be an issue.

There are also fees associated with most business credit cards. If you forget or are unable to pay your credit card bill by the due date, you will likely be charged a late fee.

When a Business Credit Card Makes Sense

A business credit card may make sense if you want to keep your business expenses separate from your personal expenses. Also, if you are interested in building your business credit history and want to earn rewards on business expense spending, business credit cards may be a good fit for your business.

Alternatives to Business Credit Cards

If a business credit card doesn’t make sense for your situation, there are alternatives. A business line of credit or a small business loan are two popular alternatives to a business credit card.

Business Lines of Credit

A business line of credit, like a small business loan, is an alternative to a business credit card if your business needs a way to cover short-term business expenses. A business line of credit works more like a credit card than a traditional loan. With a business line of credit, you can access financing through revolving credit up to an approved limit, instead of receiving a lump sum like with a traditional loan. You then make monthly payments on what you borrow from the business line of credit, and are only charged interest on what you owe.

Small Business Loans

Small business loans are also called commercial loans. A small business loan can be used as financing for business-related activities like purchasing inventory, starting a business, funding operating costs or managing cash flow. Small business loans can be used for equipment financing or for other business expenses. There are short-term and long-term small business loans.

Tips for Choosing the Right Business Credit Card

When choosing a business credit card, you want to understand your business expenses and what categories you spend the most on. For example, if your business spends a lot of money on office supplies, you may want to choose a card that offers rewards for that category of spending. Some business credit cards offer rewards as well, so compare those to find one that will best fit your preferences. Of course, you should also make sure that you can qualify for the business credit card that you want. Most business credit cards require a good personal credit score, but some accept applicants with a fair credit score.

The Takeaway

Business credit cards can be a great way to keep track of your business expenses, build credit, and earn rewards. However, business credit cards may not be a good choice for all businesses. If you might overspend on a business credit card or don’t have good credit but still need a way to cover short-term business expenses, you could look into alternatives like business lines of credit or small business loans.

If you do decide to apply for a business credit card, be sure to do your research to choose the right one for your business’s qualifications and needs. SoFi’s marketplace can help you find the right business credit card for your business’s needs.

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

Do business credit cards affect personal credit?

Business credit cards can impact your personal credit score because your personal credit score is part of business credit card applications. Also, business credit card issuers can report negative activity to consumer credit bureaus.

Can I get a business credit card as a sole proprietor?

Yes, a sole proprietor can get a business credit card. If you apply for a business credit card as a sole proprietor, the lender will likely use your personal credit history for qualification. This can be an option if you want to get a business credit card without a business, like if you are a freelancer.

What credit score is needed for a business credit card?

Minimum credit scores for business credit cards will vary by the lender and product. In general, you need a FICO credit score of at least 670 to qualify for a business credit card.

Are business credit card rewards taxable?

Business credit card rewards are not considered income, so they are not taxable.

How many business credit cards can a company have?

There is no formal limit to the number of business credit cards a company can have. However, issuers have different qualifying guidelines and restrictions for their own products.

Photo credit: iStock/Drazen_

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

SOSMB-Q425-019