If you run a business, you've obviously heard of “Earnings Before Interest, Taxes, Depreciation, and Amortization”, better known as EBITDA.
EBITDA is considered a reliable measure of a company's financial performance. This income metric is most useful for investors; however, entrepreneurs can use it too.
But how does EBITDA work - and, more importantly, what advantages does it pose for your creative small business? Keep reading to uncover the basics of EBITDA to gauge how profitable your small business really is.
EBITDA (pronounced EE-BIT-DAH), or earnings before interest, taxes, depreciation, and amortization, is a calculation of an organization’s bottom line and overall performance. It is used as an alternative to the net income, but only in some circumstances.
EBITDA acts as a proxy parameter for cash flow and lets banks and investors assess how much debt your company can take on its balance sheet.
As a result, this metric gives your investors an indication of your company’s ability to not only generate cash but also service its debt. These are two important considerations from an investment perspective.
While businesses are not legally required to reveal their EBITDA, according to the Generally Accepted Accounting Principles (GAAP), it can be calculated and reported using the data in the company's financial statements.
To make the right use of EBITDA, you need to understand what each component of the formula means.
- Earnings or Net Income: It is simply what your company earns over a certain period of time, minus the operating expenses. You can think of the net income as the profit your business made.
- Interest: An interest expense refers to the cost of servicing debt. It can also represent interest earned, although generally in EBITDA, this component is an expense.
- Taxes: The tax levied by the IRS.
- Amortization: This is a method of spreading the cost of an intangible asset (such as patents, trademarks, and copyrights) over time, usually the course of its useful life. The goal of amortizing an asset is to match the expense of acquiring it with the revenue it generates.
- Depreciation: Just like amortization, depreciation is also a method of spreading the cost of an asset over a specified period of time. The only difference is that depreciation is used for tangible assets such as manufacturing equipment, business vehicles, and computers.
Once you are familiar with the components, you can now start calculating your EBITDA.
Here's the simple formula you can use to calculate EBITDA for your business:
EBITDA = Revenue - Expenses (excluding interest, taxes, depreciation, and amortization)
Or, in other words,
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
Let's take the example of Aleena, a small business owner from Boston that runs a handmade jewelry store. Her contemporary designs took off this year, and after subtracting the expenses from her revenue, her net income is at $1.2 million.
The other financial details of her business are as follows:
• Interest paid: $360,000
• Taxes paid: $112,500
• Depreciation: $80,300
• Amortization: $10,000
If Aleena uses the formula, the total EBITDA for her business would be calculated as:
$1.2 million + $360,000 + $112,500 + $80,300 + $10,000 = $1,762,800
The EBITDA margin was developed as an accounting method to calculate a more pragmatic profit picture for your business. To determine your EBITDA margin, you must first calculate the EBITDA and then divide that total by the total revenue:
Here’s the EBITDA margin formula:
EBITDA margin = EBITDA ÷ Total revenue
Let's look at an example to better understand the importance of the EBITDA margin.
Kelsey owns a small digital marketing agency in Delaware. The total revenue that her firm generated this year amounts to $7 million, while the EBITDA comes up to $700,000. As per the formula:
$700,000 ÷ $7,000,000 = 10%
So the total EBITDA margin for Kelsey's agency will be around 10%.
The EBITDA margin shows how many operating expenses are eating into your company's gross profit.
EBITDA offers a clearer insight into a company's operations by ruling out the expenses that can obscure the company's actual performance. It can also be used to analyze profitability among companies and industries, as it eliminates the effects of finances and capital expenditures.
EBITDA is a good measure of the core profit because it removes some of the extraneous factors and enables a more direct comparison. However, it can also be misused to make a company's earnings appear greater than they really are.
Companies tend to highlight their EBITDA performance the most when they do not have very impressive (or positive) net income. It's not always a sure-shot sign of a malicious trick, but EBITDA can sometimes be used to distract investors from the lack of actual profitability.
Amortization is often used to expense the cost of software development or any kind of intellectual property. This is one of the main reasons why early-stage tech companies use EBITDA when dealing with investors and analysts.
EBITDA is generally used to compare the value of two companies from the same sector to ensure a fair equivalence.
Moreover, EBITDA is commonly used by buyers and investors to compare business valuations. Small business owners can also quote EBITDA to communicate the value of their company if they choose to sell it.
In case you're trying to pay off any debt on your long-term assets, you can use EBITDA as a shortcut to estimate the available cash flow.
The best part about EBITDA is that it gets rid of unhelpful variables like company tax rates, depreciation, and amortization, which are unique from company to company. This helps in creating a realistic picture of a company’s operating performance.
The main drawback of EBITDA is that it does not fall under the Generally Accepted Accounting Principles (GAAP). And since EBITDA is a "non-GAAP" measure, its calculation can vary from one company to another.
It's a major red flag when a business uses EBITDA prominently and hasn't done so anytime in the past. This may be because the company has borrowed heavily or is experiencing incremental capital and business development costs. In those cases, EBITDA can serve as a distraction for investors.
Other drawbacks include:
- If you spent money on an asset to use it for your business, EBITDA won't take that cost into account.
- It also eliminates the cash required to fund working capital and replace older equipment.
- EBITDA can make a business look less expensive than it actually is on paper.
Both EBT and EBIT are variations of the EBITDA parameter and are quite similar.
EBT (earnings before tax) shows the operating profit generated before taxes, while EBIT (earnings before interest and taxes) excludes both taxes and interest expenses.
To calculate EBIT, you need to look at the income statement of a business. Simply take the total revenue of your business and then remove all of the operating expenses.
This includes employee salaries, cost of goods, marketing expenses, and rent, along with associated overhead, depreciation, and amortization.
Here's how you can calculate EBIT:
EBIT= Net Income + Interest Expense + Tax Expense
To calculate EBT, you take your net income and add the taxes back to estimate the profit.
Investors can use EBT to analyze a company's operating performance after eliminating the variables outside of its control. In the United States, this is the most useful yardstick for comparing companies with different state or federal taxes.
EBITDA is a quick way to measure an organization’s financial health. It's a useful formula for businesses with long-term growth potential that are looking for investors.
However, spending all your time and resources on calculating EBITDA and other business expenses doesn't leave you any room to expand your creativity and thrive in your niche.
Luckily, a professional, affordable solution like Fincent can help you out. We simplify money management for your small business by looking after your bookkeeping, so that you're free to do what you do best: create.