Accounting terms are thrown around a lot when you’re a business owner. And ‘EBITDA’ is one that’s likely to come crawling out of the woodwork fairly often when having financial conversations with your accountant, investors and other financial stakeholders.
But what exactly does EBITDA mean? And why is it such a useful metric?
What is EBITDA?
EBITDA is an acronym that stands for ‘Earnings Before Interest, Taxes, Depreciation and Amortisation’ and it’s used to measure the overall financial health of the business.
If you’re new to accounting terminology, you may be confused already. So let’s quickly look at each of those terms to fully understand what EBITDA means in the real world:
- Earnings = your net income or profits. In other words, the money that’s left over from your income once you’re taken away things like expenses and any other deductions.
- Interest = the expense (or money paid out) against any funds or money you’ve borrowed to finance the running of the company.
- Taxes = the money you’ve paid in corporation tax, value-added tax (VAT), general sales tax (GST) or any other business taxes paid to your local revenue.
- Depreciation = the way in which accountants allocate the cost of a tangible asset (like a piece of equipment, or a company van) over its useful life. Depreciation is used to account for the decline in value of an asset.
- Amortisation = how accountants allocate the cost of an intangible asset (in financial terms, things like stocks or bonds) over a period of time. Amortization can also refer to the repayment of loans over time.
How is EBITDA Used?
EBITDA is used as a financial metric to measure your company’s financial performance. It’s often seen as an alternative measure to more common metrics such as net income or revenue.
As a business owner, EBITDA tells you two important things:
- It gives you a clear idea of your company’s value.
- It demonstrates the worth of your company to buyers and investors.
By calculating your EBITDA figure (see the formula below), you can quickly evaluate your company’s overall operating performance, by eliminating the effects of financing, government or accounting decisions to reveal a more realistic view of the income and profits you’re generating.
Some business owners see EBITDA as a proxy for cashflow, but operating cashflow is actually a far more accurate and detailed overview of the cash that’s coming into (and out of) the company as a whole.
The formula for calculating EBITDA is as follows:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortisation
If we put this into a real-world example, the numbers would look something like this:
Net income £40,000
Depreciation and Amortization +£20,000
Interest expense +£10,000
EBITDA is seen as a more realistic metric because it focuses more on the financial outcome of operating decisions made by you, your board and your management team.
Why is EBITDA important?
By removing the impacts of non-operating decisions made by the existing management – things like the interest expenses, taxes, or significant tangible and intangible assets that make up the ‘ITDA’ part of the acronym – you come to a figure that’s a more revealing metric of true performance and profitability.
This EBITDA metric levels the playing field between different companies, sectors and industries, making it easier for you (and potential buyers or investors) to compare your performance and profitability against other businesses – a vital tool when tracking yourself against competitors or looking at mergers and acquisitions (M&A) etc.
As a metric, EBITDA is not universally loved. Some investors, including such big players as Warren Buffett, dislike EBITDA as a measurement of a company’s earning potential, as it doesn’t account for the cost of debt capital or its tax effects. EBITDA is also not part of the Generally Accepted Accounting Principles (GAAP) used by the accounting industry.
But, if you’re looking to get a deeper understanding of the overall performance of your business, EBITDA can be a useful metric to track when looking at business decision-making, financial planning and other strategic analysis.
- Show profitability by eliminating financing effects and accounting decisions
- Give you a clear idea of your company value
- Demonstrate your worth to buyers and investors
- Allow comparisons across different business types and industries.
If you’d like more helpful tips on financial management, there are plenty of useful business accounting, finance and cashflow posts available via the Fluidly blog.