What is EBITDA?
Earnings before interest, taxes, depreciation, and amortization (EBITDA, for short) is a metric that measures financial performance. Companies might find it a useful alternative to calculating net income. That’s because it figures out earnings without considering any accounting or financial deductions like tax, interest, and debts, so you can ignore all the costs not related to your core operations.
EBITDA gained popularity in the 1980s and continues to be a popular metric for calculating financial performance. As well as overlooking interest and taxes, this metric doesn’t consider depreciation or amortization—two accounting techniques used to figure out the value of large investments.
There are two ways to work out EBITDA. You can either use net income to measure profitability:
EBITDA = net income + taxes + interest expenses + depreciation and amortization
Alternatively, you can use operating income in your calculation:
EBITDA = operating income + depreciation and amortization
Companies can find all the figures needed to make these calculations on their balance sheets and income statements.
A more accurate measure for calculating financial performance is EBITDA margin, where you divide your EBITDA by total revenue. For example, a company with an EBITDA of $1M and total revenue of $2M has an EBITDA margin of 0.5 or 50%. Generally, a high EBITDA (>15%) means you have stable earnings and profitable operations. A low EBITDA (<15%) means you might have issues with profitability or cash flow.
Using EBITDA can give you a better understanding of profitability by excluding accounting and financial deductions. Some companies use this calculation to compare financial performance with their competitors. However, Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS) don’t recognize EBITDA because it is a calculation of financial performance without considering interest, taxes, and debts. It completely ignores those financial burdens and so might produce misleading results about the financial health of a company.
Another thing to note is that companies with lots of assets and high depreciation might appear to have a higher EBITDA than those with fewer assets and low depreciation. That can make some companies appear more successful than they actually are.
An alternative to the EBITDA metric is earnings before interest and taxes (EBIT), which measures performance without interest and tax expenses but considers depreciation and amortization. Some companies might find this metric more valuable than EBITDA for calculating profitability.
EBITDA case study
A business owner in Los Angeles wants to calculate EBITDA using her operating income of $100,000. Her depreciation and amortization expenses are $50,000. She uses the following formula:
EBITDA = operating income + depreciation and amortization
Her EBITDA is $150,000.
Next, she calculates her EBITDA margin by dividing her EBITDA by her total revenue of $5M. Her EBITDA margin is 30% (150,000 / 5,000,000). This number suggests she has stable earnings and profitable operations.
The bottom line
Earnings before interest, tax, depreciation, and amortization is a metric used by some companies to measure profitability. It calculates your earnings without considering any accounting or financial deductions like tax, interest, and debts. GAAP and IFRS don’t recognize EBITDA as a viable metric.
