If you’re new to business — or even if you’re not — EBITDA (e-bit-dah) may look hard to pronounce, but it doesn’t have to be hard to understand. Once you become familiar with its meaning, variables and formulas, you’ll be speaking EBITDA in no time. Let’s get started.
What does EBITDA stand for?
EBITDAstands for earnings before interest, taxes, depreciation and amortization. It’s a metric for understanding 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.
Step one in understanding EBITDA is to break down the acronym into its pieces:
Earnings: The money your business brings in during a certain period, typically measured in months or quarters
Interest: The extra money you pay to lenders, in addition to the principal amount you borrowed
Taxes: The dues you pay to local, state or federal authorities as part of your business’s activities
Depreciation: Gradual reductions in the value of your existing tangible assets such as computers, Point of Sale (POS) systems, office supplies, inventory or other capital expenditures
Amortization: Similar to depreciation, but for intangible objects (think of reductions in loan payments over time or the worth of proprietary software)
Why is EBITDA important?
EBITDAcan be useful in many ways. It offers different benefits to various types of business stakeholders.
It helps measure business success
Many nonoperating expenses — like taxes, interest payments and depreciation of tangible and intangible expenses — can vary greatly from year to year or between different businesses, industries and tax jurisdictions. This can make understanding your success difficult. EBITDA simplifies the process, allowing you to compare your raw earnings within your own business over time and gauge how you stack up against your industry peers.
It helps lenders evaluate risk
If you’re looking to purchase new equipment, expand your business or make any other capital investment, you may need a business loan or line of credit. Banks and other lenders often consider your company’s EBITDA when deciding whether your business is a risk they’re willing to take on. 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.
It gives investors valuations for buyouts
One of EBITDA’s main uses is for business valuation. Many potential investors use a variation of EBITA, known as the EBITDAmultiple, to compare businesses within the same industry that are similar in size and scope. Comparing a business’s value with its raw earnings can help investors make acquisition decisions.
How do you calculate EBITDA?
Once you know your formula, calculating your business’s EBITDA is a fairly simple process. Before you get started, you’ll want to have your business’s current financial statements handy — specifically your income statement and balance sheet.
There are two common formulas for calculating EBITDA. Whichever formula you choose, be sure to stick with it as you continue to calculate your business’s EBITDA over time to ensure consistency.
