EBITDA is an acronym that stands for earnings before interest, taxes, depreciation, and amortization. The EBITDA formula is a common way for companies to assess their performance. By looking at earnings without deducting taxes, interest, or other expenses, it’s easier to assess business results and compare them to other companies in the same industry.
The EBITDA formula can also be useful for investors. When investing in the stock market, it’s important to research companies before buying shares of their stock, and EBITDA is a basic measure of profitability that can help investors gauge an organization’s performance.
What is EBITDA, and how is EBITDA calculated?
The EBITDA formula is a way of considering a company’s net income — without deducting costs like interest, taxes, depreciation, and amortization. The idea is to create a more apples-to-apples view of how different companies’ perform. Two similar companies in the same industry could have very different tax rates or different capital structures (which can impact debt, and therefore interest paid), making it hard to compare one to the other.
By not deducting certain expenses that aren’t related to performance, EBITDA helps level the playing field.
EBITDA is also relatively easy to calculate. The information can be found on a company’s balance sheet and income statement. Here’s a quick breakdown of each letter of the acronym, and why it matters in the EBITDA formula:
Earnings
Earnings are a company’s net income over a specific period of time like a fiscal year or a quarter. This number can be found on the company’s income statement; it’s essentially the bottom line, after subtracting all expenses from total revenue.
Interest
This refers to any interest that the company pays on loans and debts. In some cases interest might include interest income, in which case you’d use the total interest amount (interest income – interest paid). Interest is added back to total earnings in the EBITDA formula because the amount of interest paid depends on the types of loans and funding a company has. This number can muddy the waters, when trying to compare two companies that might have very different financing situations.
Taxes
Federal, state, and local taxes are also added back because tax rates depend on where a company is based geographically, and where they conduct business. Thus, taxes aren’t something that a company has much control over, so they aren’t an indicator of performance.
Depreciation & Amortization
Depreciation calculates the decreasing value of tangible physical assets over time (e.g., equipment, vehicles, buildings, etc.). Amortization is a way to account for the expenses of non-tangible assets like intellectual property, like patents and copyrights.
Depreciation and amortization are added back to earnings because they are non-cash expenses. As such, they don’t necessarily reflect on a company’s overall performance or profitability.
EBITDA Formula and Calculation
EBITDA can be calculated simply by adding a company’s interest, taxes, depreciation, and amortization to net income. Another method is to add a company’s operating income — or Earnings Before Interest and Taxes (EBIT) to its non-cash expenses of depreciation and amortization.
Earnings, or net income, can be calculated as follows:
Net income = Revenue – Cost of Goods Sold – Expenses
How to calculate EBITDA
EBITDA = Net Income + Taxes + Interest Expense + Depreciation & Amortization
Or
EBITDA = Operating income (EBIT) + Depreciation & Amortization
For example, if a company has $4,500,000 in revenue and $500,000 in expenses, their operating income (EBIT) is $4,000,000.
If the company’s assets have depreciated by $100,000 and they have an amortization amount of $75,000, the calculation would be as follows:
EBITDA = $4,000,000 (EBIT) + $100,000 (D) + $75,000 (A)
EBITDA = $4,175,000
It’s possible for EBITDA to be negative if a company has significant losses within a particular quarter or year.
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 Does EBITDA Differ From Other Measurements of Income?
There are a number of different ways to view an organization’s income, each with their pros and cons. Depending on which lens you use, or which formula, one metric can provide insights into a company’s performance that another won’t. Here are a few common measurements of company income:
• Cash Flow is an analysis of the amount of money coming into a business versus the amount of money going out. Because of timing issues with sales, you can be profitable without being cash flow positive and vice versa.
• EBIT is also known as operating income, as discussed above. EBIT adds back the expenses related to interest and taxes, but keeps deductions for depreciation and amortization to give a clearer picture of a company’s earnings inclusive of actual operating costs.
• EBT is another variation on EBIT. It allows for interest expenses, but eliminates the impact of taxes — since a company’s tax burden has nothing to do with its performance.
• Net Income appears at the bottom of an income statement, after subtracting all business expenses (including interest, taxes, depreciation, and amortization) from total revenue.
• Revenue is also called gross income. It specifically refers to the money a company earns from sales. As such, it’s really only a window into one aspect of the business’s performance.
Understanding company performance can be a complex endeavor, and it’s best to use a combination of metrics that are most meaningful for that company or industry.
Why Is EBITDA Important?
The EBITDA formula is useful because it provides a view of company profitability, without the impact of capital expenditures and financing. By using the EBITDA formula, analysts can compare companies within an industry and investors can quickly evaluate companies they might want to invest in.
In that way, EBITDA can also be a tool used by financial advisors to help their clients make investment decisions.
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. Business owners can use the EBITDA formula to gain insight into operating performance, how their company stands in relation to others in the same industry, and the company’s ability to meet its obligations and grow.
What Makes a Good EBITDA?
EBITDA is a measure of a company’s performance, so higher EBITDA is better than lower EBITDA when comparing two or more organizations in the same sector. This is important, because companies that vary in size or operate in different sectors can, of course, also vary widely in their financial performance. So one way to determine whether a company has “good” EBIDTA is to compare it to others of a similar size in the same industry.
Here are two other ways to gauge whether a company’s EBIDTA is good or not.
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.
EBITDA Margins
Another 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 portion 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. For example: EBIDTA is considered a “non-GAAP” measure, meaning it doesn’t fall under generally accepted accounting principles (a set of rules issued by the Financial Accounting Standards Board and procedures commonly followed by many businesses). This also means that the way EBIDTA is calculated isn’t wholly standardized.
Thus, companies also may not 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.
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.
Or, because EBITDA tends to obscure the impact of debt and capital investments, a company that’s spending heavily on development costs, or has incurred a lot of debt, may look more robust than it is.
Also, the formula doesn’t work well with certain types of companies, such as companies that have a need to constantly upgrade their equipment.
The Takeaway
Comparing companies you may want to invest in can take a lot of time and technical analysis. If you’re choosing your first stocks, the amount of information and choices can be overwhelming. EBITDA is one measure of company performance that can be useful, because it takes net income and then removes certain factors that can be confounding: interest paid or earned; federal, state, and local taxes; the impact of capital depreciation and amortization.
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