How To Calculate and Use EBITDA (2023)

Picture this scenario: A producing company reports little profit because of large expenses that reflect the damage and tear on factories and machinery, in addition to interest costs on borrowed money. This will not be appealing to potential investors at first glance, so executives resolve to present a more favorable measure of monetary performance often known as EBITDA, which ignores lots of these expenses.

Here’s what that you must find out about EBITDA, plus how businesses use it alongside standard measures of profitability.

What’s EBITDA?

EBITDA is an acronym for earnings before interest, taxes, depreciation, and amortization. It is often utilized by corporations with large capital expenses, comparable to manufacturers, and by early stage technology corporations that are usually not yet profitable and spending heavily on research and development. 

EBITDA became popular within the Nineteen Eighties, when acquired corporations with heavy debt financing—a process often known as a leveraged buyout— were evaluated based on their ability to service the debt within the short term. Thus, amortization and depreciation weren’t deemed immediately relevant. Interest and taxes are also excluded since those undergo changes during acquisition and modify the corporate’s capital structure.

EBITDA is typically useful since it shows an organization’s ability to generate money earnings by excluding many non-cash expenses from its income statement. EBITDA also excludes interest and taxes because interest costs rely upon how much an organization borrows, and taxes can vary depending on an organization’s location and tax rates. These exclusions mean EBITDA is higher than net income—and even positive when an organization has net losses.

The right way to calculate EBITDA

Probably the most common option to calculate EBITDA starts with earnings, or net income. From there, expenses for interest, taxes, depreciation, and amortization are added back. The EBITDA formula subsequently is:

Earnings + interest + taxes + depreciation + amortization = EBITDA

The challenge in determining EBITDA is finding the depreciation and amortization amounts, in addition to interest and income taxes. This might require searching in places beyond the primary income statement, comparable to supplements and management notes. Depreciation and amortization often might be present in an organization’s money flow statement, specifically the money flow from operations.

EBITDA components

EBITDA accommodates the next components:

Earnings

That is the underside line, or net income, on an income statement in any case money and non-cash expenses are subtracted. EBITDA calculations normally start here, although you would also start with operating income or earnings before interest and taxes (EBIT). In that case, only depreciation and amortization have to be added back.

Interest

Interest expense on debt is listed before taxes because the fee is tax-deductible, lowering an organization’s taxable income. For instance, if Company A and Company B each have operating income of $20 million, but Company A paid $5 million in interest, its taxable income is $15 million, while debt-free Company B’s taxable income is $20 million, since it has no interest expense to deduct.

Taxes

An organization’s income tax expense relies on its taxable income and its percentage tax rate. Income tax is often the next-to-last line on the income statement before net income. Property taxes are included in operating expenses. Capital gains taxes appear below operating income and are taxed at different rates, depending on how long a capital asset was owned. Per the above example, assuming each corporations are taxed at 20%, Company A pays $3 million in taxes and Company B pays $4 million. For purposes of EBITDA calculations, Company A adds back a combined $8 million from interest and taxes while Company B adds back only $4 million from taxes.

Depreciation

Depreciation is a non-cash expense that represents the estimated decline in productive value of an organization’s tangible assets, comparable to property, plants, and equipment. Imagine a manufacturer that buys latest machinery for $50 million with an estimated useful lifetime of five years. To account for the damage and tear on the assets, the corporate records a $10 million non-cash expense in each of the subsequent five years to represent the declining value, although it paid upfront for the machinery. 

Amortization

Amortization, like depreciation, is a non-cash expense. It accounts for the estimated reduction in value of intangible assets, comparable to software development and mental property, including patents, trademarks, and copyrights. Unlike depreciation, which may vary based on assumptions about an asset’s useful life and the way much to depreciate every year, amortization typically follows a set schedule, comparable to 15 years in equal annual expense.

Importance of EBITDA

Using EBITDA might be helpful to business managers and financial professionals in several ways, including: 

It helps you give attention to operations

Setting aside the non-operating expenses of interest and taxes, in addition to the non-cash items of depreciation and amortization, makes it possible to investigate an organization on the strength of its core operations and talent to generate money. EBITDA is typically known as a normalized measure of performance.

It lets you make comparisons

Removing non-cash expenses, which may differ dramatically from company to company, makes it easier to match different corporations and their ability to generate EBITDA as a share of revenue (a measure that’s much like profit margins).

It’s capital-structure neutral

EBITDA removes any bias about an organization’s selection of debt or equity to fund operations, again showing how an organization’s underlying operations perform.

It helps you to assess debt service ratios

EBITDA can provide a clearer picture of an organization’s ability to pay interest on debt, using ratios comparable to EBITDA-to-interest-expense. For instance, if an organization has annual EBITDA of $20 million and interest expense of $2 million, its debt-service coverage ratio is 20-to-2, or 10. Higher is best for this ratio.

It’s useful for valuation

In determining an organization’s value for possible sale to investors or one other company, EBITDA is a key metric. A standard measure is enterprise-value-to-EBITDA. An organization’s enterprise value is the whole market value of its shares, plus its debt. So, for instance, if an organization has an EBITDA of $20 million and similar corporations have been sold at prices representing 10 times EBITDA, then the corporate could be valued at about $200 million.

Limitations of EBITDA

EBITDA may not all the time be the most effective option to assess an organization’s financial performance. Amongst EBITDA’s limitations:

It ignores interest and taxes

These are real money costs that represent money going out the door, and so they reduce an organization’s profit.

It neglects asset deterioration

Considered one of the largest criticisms of EBITDA is that it pretends that assets don’t decline in value. Some leading investors, including Warren Buffett, chairman of Berkshire Hathaway Inc., have said depreciation and amortization represent real costs which might be properly reflected within the income statement. Neither does it account for capital expenditure crucial to repair or replace worn-out assets.

It overstates profitability

Because EBITDA is larger than net income by excluding various expenses, the market valuation of an organization could seem inflated. EBITDA could make an organization look more profitable than it truly is; in lots of cases, corporations with positive EBITDA report losses on the income statement.

It’s not GAAP-approved

EBITDA is an improvised measure, not approved under generally accepted accounting principles (GAAP). Net income is approved since it uses accrual accounting to match income with associated expenses over time. Corporations may present EBITDA to investors at the side of net income, but not in its place.