EBITDA is an acronym that stands for “earnings before interest, taxes, depreciation, and amortization.” It’s a business metric used to assess a company’s financial health and ability to generate cash.
In this guide, we’ll break down the components of EBITDA, how to calculate it, and when this key metric can come in handy for your small business.
What is EBITDA?
EBITDA is often used to gain insight into a company’s profitability. Let’s break down the different components to understand what EBITDA can indicate:
- Earnings: the amount of money your business earns over a certain period (usually months or quarters).
- Interest: the extra money you pay to lenders in addition to the initial principal amount you borrowed.
- Taxes: any local, state, or federal taxes you paid as part of your business activities.
- Depreciation: the gradual reduction in value of existing tangible assets such as buildings, equipment, or certain other capital expenditures.
- Amortization: the allocation of intangible assets, such as intellectual property or the worth of proprietary software.
EBITDA is used to indicate a company’s financial performance and profitability. “Stripping away extraneous factors such as interest, taxes, depreciation and amortization (the last four letters in the acronym) from total earnings provides a clearer, more accurate measure of a company’s cash flow — especially compared with that of competitors,” wrote Chase for Business.
EBITDA is not a GAAP or IFRS-approved metric, and some investors are wary of using this measurement. EBITDA’s limitation is that it presents the company as if the business has never paid any interest or taxes. For accounting purposes, EBITDA is not always the most accurate depiction of your company’s financial position. Instead, it’s best used as a benchmark against your competitors and others in your industry.
[Read more: What is a Business Valuation, and How Do You Calculate It?]
Once you know your EBITDA, you can measure your results against similar businesses in your industry.
How to calculate EBITDA
There are two EBITDA formulas you can use that give you essentially the same result.
The first formula uses net income, which is your operating income minus nonoperating expenses (taxes and interest, for instance):
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
An alternate option is to start with your operating profit, which reflects your net income, interest, and taxes. To simplify:
EBITDA = Operating profit + Depreciation + Amortization
How do these formulas work in practice? Imagine your business brought in $850,000 last year. After $400,000 in cost of goods sold and $300,000 in operating expenses like rent, wages, and utilities, you also recorded $30,000 in depreciation and $10,000 in amortization. That leaves you with $110,000 in operating profit. Subtract $15,000 for interest on a loan and $20,000 in taxes, and the net income is $75,000.
Working the first formula starts with the net income of $75,000 and adds back $15,000 of interest, $20,000 of taxes, $30,000 of depreciation, and $10,000 of amortization, for an EBITDA of $150,000.
The second formula gets the same number but with less arithmetic. The operating profit of $110,000 already excludes interest and taxes, so add back the two noncash items — $30,000 of depreciation and $10,000 of amortization — and again that figure is $150,000.
[Read more: Concerned About Your Business's Financial Health? Here Are 6 Methods for Measuring Profitability]
When to use the EBITDA calculation
EBITDA is commonly used by businesses, valuators, bankers, and investors to understand a company’s profitability, performance, and valuation.
EBITDA’s main use is in business valuations. Potential investors use EBITDA to compare similarly sized businesses within a specific industry. EBITDA allows investors to compare a company’s value against those of other companies using a standardized measure in order to make better acquisition decisions.
Likewise, this metric is also used to assess risk. “Banks and other lenders often consider your company’s EBITDA when deciding whether your business is a risk they’re willing to take on,” wrote Chase for Business. “EBITDA is used to determine a company’s debt service coverage ratio, which shows potential lenders how well you’ll be able to repay the loan and meet other short-term obligations.”
For your own purposes, EBITDA removes some of the variable costs that can make it difficult to assess your business success. Taxes, interest payments, and depreciation all change from one year to the next. EBITDA allows you to compare your company’s raw earnings over time, giving you a clearer picture of your position in the market.
What is a good EBITDA margin, and how does yours compare by industry?
Once you know your EBITDA, you can measure your results against similar businesses in your industry. What qualifies as a “good” EBITDA varies based on your business expenses, cash flow, and specific industry. “The EBITDA ratio varies by industry, but as a general guideline, an EBITDA value below 10 is commonly interpreted as healthy and above average by analysts and investors,” wrote the BDC.
However, the EBITDA margin formula gives you a way to evaluate your business’s EBITDA. The margin formula is:
EBITDA margin = EBITDA ÷ Total revenue
For example, if your EBITDA is $500,000 and your total revenue is $5 million, your EBITDA margin is 10%.
“Publicly traded companies have average EBITDA margins in the low teens, though they vary widely by industry,” wrote Chase for Business.
EBITDA vs. net income: What's the difference, and when does each matter?
EBITDA and net income are two accounting terms that give you insight into your business’s financial performance. Net income is the profit your company makes after all expenses, taxes, and deductions are subtracted from the total revenue. Net matters for taxes and for anything tied to earnings that you can actually distribute.
EBITDA matters in a sale for fundraising. Small business valuations are routinely quoted as a multiple of EBITDA. By stripping out interest, taxes, depreciation, and amortization, it isolates how the core operation performs before financing and accounting choices enter the picture. It helps an owner determine whether a weak year came from the operation itself or from its debt load.
How lenders and buyers use EBITDA to value your business
Investors use EBITDA because it strips away four financial metrics that can vary widely between businesses and skew how strong a business looks on paper.
“Buyers use EBITDA because it removes factors like taxes, debt service, and accounting decisions, giving a clearer view of a company’s core operational performance and making it easier to compare businesses,” wrote IBG Business.
Two companies with the same revenue, the same customers, and the same cost structure can post a very different net income purely because one carries debt and the other doesn't. EBITDA makes the comparison easier. That's why it’s also particularly appealing for lenders that bring their own financing and tax situation.
EBITDA is purely one data point. Lenders and buyers will do their due diligence, assessing other factors as well, such as debt obligations, tax liabilities, cash flow, and other elements, to arrive at a company value. EBITDA is a comparison tool, not a measure of what the business generates in cash.
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