When investing in the stock market, it’s important to research companies before buying shares of their stock. One good way to evaluate a stock is by using the EBITDA formula. Business owners can also calculate their own EBITDA, which can help keep track of performance year after year and can help secure investment and financing.
The EBITDA formula is calculated to measure the financial performance and earnings of a company. It’s an indicator that looks at performance without including complex factors such as accounting choices and tax environments. It includes more useful information than just cash flow or operating income.
In other words, it’s an excellent way to find out how a company handles its operating costs, what its cash flow looks like, and how well it’s really doing financially. Merely looking at net income doesn’t always provide the full picture of how a company is doing.
What does EBITDA Stand For?
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Here’s a quick breakdown of each letter of the acronym:
Earnings are equivalent to a company’s net income. This number can be found on the company’s income statement.
Some items are not included in the EBITDA calculation’s final profit measure of a company, namely, interest, tax, depreciation, and amortization. Usually, companies subtract these from their net income, so they need to be added back in.
This is any interest that the company pays on loans and debts. The reason interest isn’t included is that interest amounts depend on the type of loan and funding a company is paying back. This number can affect a company’s worth in deceiving ways.
Federal, state, and local taxes are excluded because tax rates depend on where in the world the company is based and where they conduct business. For this reason, taxes aren’t something that a company has much control over, so they aren’t an indicator of performance.
Depreciation involves the reduced values of physical assets over time. This is excluded because companies need to purchase new and updated equipment and hardware to provide products and services.
This depends on the debt a company has and varies greatly from company to company, depending on their individual situation. For this reason, it isn’t useful when trying to compare companies to one another.
A more specific EBITDA formula is LTM EBITDA, or Last Twelve Months EBITDA, also called Trailing Twelve Months EBITDA (TTM). This calculation finds EBITDA for only the past year.
How to Calculate EBITDA
EBITDA is found by adding a company’s operating income to its non-cash expenses of amortization and depreciation. It can also be calculated by adding a company’s amortization, interest, taxes, depreciation, and net income.
In other words:
EBITDA = EBIT + Amortization + Depreciation
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
For example, if a company has $4,500,000 in revenue and $500,000 in expenses, their operating profit (EBIT) is $4,000,000. If the company’s assets have depreciated by $100,000 and they have the amortization of $75,000, the calculation would be as follows:
EBITDA = $4,000,000 (EBIT) + $100,000 (D) + $75,000 (A)
EBITDA = $4,175,000
Simple steps for calculating EBITDA:
• Subtract non-tax and interest expenses from revenue.
• Record depreciation expenses of tangible assets from cash flow.
• Find amortization expenses of intangible assets from cash flow.
• Add depreciation and amortization expenses to the EBIT sum.
This information can be found on a company’s income statement. Each part of the formula will be included as line items in the statement.
It is possible for EBITDA to be negative if a company has significant losses within a particular quarter or year.
Why is EBITDA Important?
By using the EBITDA formula, investors can quickly compare several companies they might be interested in investing in. EBITDA is a tool used by many financial advisors to help their clients make investment decisions and to build portfolios. It’s also useful for business owners to calculate their EBITDA each year to see how their company is performing. This is especially important if they are looking to take out a loan or seek investment.
The EBITDA Coverage Ratio
To add more helpful information to the EBITDA calculation, the EBITDA Coverage Ratio compares EBITDA to debt and lease payments.
The EBITDA coverage ratio calculates a company’s ability to pay off lease payments, debts, and other liabilities.
The calculation for the EBITDA coverage ratio is:
EBITDA Coverage Ratio = (EBITDA + Lease Payments) / (Interest Payments + Principal Payments + Lease Payments)
A ratio equal to or greater than 1 indicates that a company will have a better ability to pay off liabilities. If the ratio is lower, a company may not be able to pay off its debts. The higher the ratio, the more solvent a company is. The current average coverage ratio is 2.
A final EBITDA calculation investors can do to learn about a company’s performance is the EBITDA Margin calculation. This formula compares annual cash profits to sales. It’s a useful indicator to find out if a company’s EBITDA is ‘good’ or not. The EBITDA Margin calculation is:
EBITDA Margin = EBITDA / Total Revenue
The resulting number is a percentage that shows what percent of revenue was able to be converted into profit within a year. The higher this percentage is, the better a company is performing because it means their expenses aren’t eating into their profits. In general, an EBITDA margin of 60% or higher is considered a good number.
Downsides of the EBITDA Formula
Although the EBITDA formula is a useful tool for investors, it also has some drawbacks. Companies with a low net income may use the EBITDA formula to make themselves look better since the EBITDA number will likely be higher than their income.
Also, the formula doesn’t work well with certain types of companies, such as companies that have a need to constantly upgrade their equipment. Companies also don’t always include the same information in each report, and they aren’t required to record all information that may be relevant to the equation. For these reasons, it’s best to calculate EBITDA along with other types of evaluations, such as net income and debt payments.
Similar Formulas to EBITDA
There are additional calculations that are similar to EBITDA. Some of these include:
• Earnings Before Interest After Taxes (EBIAT).
• Earnings Before Interest and Depreciation (EBID).
• Earnings Before Interest and Taxes (EBIT).
• Earnings Before Interest, Depreciation, and Amortization (EBIDA).
• Earnings Before Interest, Tax, Depreciation, Amortization, and Exploration (EBITDAX).
• Earnings Before Interest, Tax, Depreciation, Amortization, and Restructuring or Rent Costs (EBITDAR).
Staying Updated On The Latest Market News
While investors can make calculations to compare companies they’re interested in investing in, this can take a lot of time and technical analysis. If they’re choosing their first stocks, the amount of information and choices can be overwhelming. Much of this work is already being done by professional financial analysts.
For investors interested in learning more about specific companies, staying updated about the latest financial news and building a stock portfolio, the SoFi App is a great tool to use. SoFi provides a full suite of financial tools, all at investors’ fingertips. Investors can buy and sell stocks using SoFi Invest®, track expenses, set financial goals, and learn more about investing.
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