What is EBITDA?
Glance quickly and “EBITDA" may look like a cat ran over your keyboard - but it’s actually one of the most important metrics for your business. While not necessarily a legal requirement, EBITDA is a universally accepted value for measuring your company’s financial health. But what exactly is it?
What is EBITDA?
Whether you're running your company or examining potential investment opportunities, you can’t do anything without EBITDA. You wouldn’t recklessly throw around money without first calculating how much you had to spend, would you?
That value is EBITDA:
EBITDA is your company’s financial performance before expenses and financial decisions are applied. It gives you precise, actionable information so that you can make data driven plans to grow your company.
Calculating EBITDA is an incredibly simple process and the values are easily extracted from a company’s financial statements.
The earnings (net income), tax and interest figures are on income statements, while depreciation and amortisation values are found on the cash flow statement (or sometimes in the notes of operating expenses).
Earnings (otherwise known as net earnings or net income) are the value of the company’s sales minus the costs of goods sold (COGS), expenses, taxes, interest and depreciation. It’s a useful gauge to your company’s profitability.
Interest expenses are the costs of any borrowed capital. This can, for example, be on lines of credit, corporate bond issuances and more. Interest rates vary from company to company based on macro-economic climates, past and forecasted financial performance and many more.
One of only two certainties in life, taxes are legally imposed financial duties. Whether by a government or other authority, taxes are not necessarily linked to services rendered and can be applied to assets, events, and transactions.
Depreciation is the accounting technique used to calculate the cost of physical assets over their entire lifespan. Essentially it accounts for the loss of value of an asset over time due to wear, tear and general use. In accounting, however, it can be levered into valuable tax reductions as you account for the cost of the item over multiple time periods.
Amortisation is the gradual writing off of initial costs of an asset or debt. In business, it usually refers to the repayment plan of capital and interest plans on corporate loans. It can also be applied to expensing intangible assets such as trademarks and copyrights in a similar way to depreciation.
This leaves you with two ways to calculate EBITDA. These are:
EBITDA = Net Income + Taxes + Interest + Depreciation + Amortisation
EBITDA = Operating Income + Depreciation + Amortisation
It’s easy peasy to work out if you’ve stayed up to date with your bookkeeping!
Is EBITDA needed?
There's absolutely no requirement for companies to calculate their EBITDA.
It is purely a measure of your company’s financial health and cash income, and the government has a plethora of other information from which to officially record your company’s financial health.
However, almost every company records and publishes their EBITDA.
The reasons vary from sector to sector. For example, companies in asset intensive industries with a variety of property, plant and equipment will often place more value in their EBITDA as it avoids highlighting any potentially large depreciation costs.
Another example is for tech startups that have to invest heavily in software development or other intellectual property. EBITDA works heavily in their favour due to the figure combining the amortisation costs along with everything else.
The difference between EBIT and EBITDA?
As the canny among you will be able to infer, EBIT stands for Earnings Before Interest and Taxes are applied.
It is essentially the same value, minus the depreciation and amortisation parts added onto the calculations. But why is there a separate value for it? And is EBIT better than EBITDA?
Previous high levels of debt and fixed assets can wildly skew EBT and EBIT, dragging down the success of a company’s good financial year.
That being said, there are some rare exceptions of EBIT being more useful than EBITDA. In industries with a large time gap between high capital expenditure and cashflows, EBIT will be far more useful. This is because past capital expenditure is added back into the calculations and will not fully reflect company performance.
Example of EBITDA
Say, for example, your company generated £85 million in profits over a single year. The COGS was £30 million while your overhead costs were £15 million overall. We viewed your cash flow statements and saw that depreciation and amortisation together cost you £10 million, while your interest expenses cost another £5 million. This means that your EBT is £25 million, and with the help of excellent tax services, you paid £3.5 million in tax.
Net Income + Interest + Taxes + Depreciation + Amortisation
(21.5 + 5 + 3.5 + 10) million
Your EBITDA would be £40 million in this case.
Ever wanted to know what potential investors are thinking?
Why is EBITDA valuable?
The EBITDA formula provides a comparable value to that of a company’s cash flow. It can break down the total amount of cash a company has received and is available to use in the future.
By conducting company analysis and calculating your EBITDA, you can:
1. Determine the current amounts of cash available for reinvestment or to service debts.
2. Gain an overview of the current status of the company’s cash flow.
3. Compare and contrast competitor values to better understand your business compset.
What does EBITDA mean to investors and business leaders?
EBITDA is a clear demonstration of a company’s true worth and underlying profitability. It’s also a public announcement that can be viewed by potential investors and other business leaders as an example of how well a company is performing. As almost every company uses EBITDA, you can clearly draw profitability comparisons between competitors, sectors and industries across the board.
When you compare the EBITDAs of two separate businesses to each other, you can gain a relatively clear view of cash flow throughout. The higher the EBITDA, the better the cash flow of a company, if your EBITDA is negative, then the cash flow is extraordinarily poor.
EBITDA has the added bonus of stripping away the effects of financing, foreign taxation environments and other accounting decisions - giving a much clearer view of company finances.
EBITDA vs. operating cash flow
Gross profit is the amount of revenue that is profit after production expenses are taken into account.
(Revenue – Cost of Goods Sold) = Gross Profit
Gross profit considers the cost of goods sold or the expenses related to the selling of the product or service. Gross profit doesn’t include costs and expenses such as tax and interest.
Gross profit is useful for businesses, especially those that are concerned with selling a product, as it shows the portion of each pound of revenue that the business retains.
This is different to EBITDA, although both show the earnings of the company in question the company profit is calculated in separate ways.
- EBITDA and gross profit are business metrics that are used to measure profitability in companies by removing different costs and expenses.
- EBITDA shows profitability before interest payments, tax, depreciation and amortisation.
- Gross profit shows profitability after subtracting the costs incurred when making a product or providing a service.
- EBITDA does not appear on income statements but can be calculated using income statements.
- Gross profit does appear on a company’s income statement.
- EBITDA is useful in analysing and comparing profitability.
- Gross profit is useful in understanding how companies generate profit from the direct costs of producing goods.
One metric is not better than the other and the differences are important to understand in order to use them effectively. With gross profit only operating expenses are
removed, when considering EBITDA non-cash items such as depreciation are added back onto net income.
EBITDA helps users to understand a company before management decisions, financing arrangements and accounting are carried out and shows the underlying financial performance. Gross profit is used to understand production efficiency and relates to direct production costs.
Drawbacks of EBITDA
For the majority of the business world, the EBITDA formula is extraordinarily useful. It can clear up a jumble of numbers and gives a single figure representing the finances and profitability of a business.
However, some swear against the formula has there are many potential drawbacks of EBITDA. They argue that these potential drawbacks can be dangerously misleading - hence why there is no legal requirement for companies to declare their EBITDA.
For example, many companies alter their accounting methods by treating expenses/costs in slightly different ways or categorisations. This can affect the final results of EBITDA.
As EBITDA adds on taxes, interest, depreciation and amortisation, a positive, high value EBITDA is not necessarily congruent with high profitability. Businesses that increase their debts to increase cash and assets etc. can hide severe debts behind their EBITDA and give a biased picture of their financial information.
The EBITDA formula isn’t just a set value to demonstrate the performance of your business. It can, and often is, certainly used in that way. But, it can also provide insight into a company’s potential.
Sometimes a business has to spend and invest in order to grow. If your company has lines of credit in order for a massive surge in production / growth, then other financial figures can give a biased view of your finances. With EBITDA these investments demonstrate your profitability and cash flow for all to see.
If you want to improve your EBITDA to demonstrate potential to investors, you can:
Grow sales revenue, while decreasing
COGS (Cost of Goods Sold)
That sounds all well and good as a checklist, but let’s give you some real world examples of how you can increase your EBITDA.
#1 Decreasing staff costs does not necessarily mean a reduction in the workforce. In fact, you can actually increase the effectiveness of your corporate workforce and increase EBITDA at the same time. Travel and corporate entertainment can be reduced by more virtual meetings. If the Covid era has taught us anything it’s that these virtual meetings are actually more effective than physical ones and provide a boost in productivity!
#2 Reduce your fixed costs in a number of ways. Did you know that certain services are cheaper when they are outsourced? Owned premises are always cheaper in the long run that continuously renting office spaces. Saving money on the cost of goods sold, office items and any non-essential equipment will seriously improve your EBITDA.
#3 Inventory costs. The maintenance and storage of products can be costly and prove a permanent drain on your resources and finances. With streamlined supply chains you can minimise the cost of inventory management, free up capital and boost your EBITDA.
#4 Consistently price your products. It’s occasionally a clever move to boost sales by reducing prices and offering discounts. However, if you base your prices on the quality and production of your products or services, you can increase your sales revenue and therefore your EBITDA.
Investors and finance professionals use a lot of jargon. Multiples is one such word. In simpler terms, multiples are the marketplace’s perception of potential growth of a business. If two businesses run in similar areas, with the same environment and matching characteristics of product & services, then you would expect similar multiples.
You use EBITDA multiples in order to value a company. Despite the process being variable and tricky, there are two primary ways to value a company.
Calculate the present value of future free cash flows
Review market comparable transactions
EBITDA comes into play in the latter. But let’s have an example.
A restaurant in town sold last year for £100,000 last year. This is its EV, or Enterprise Value. It’s final EBITDA was £20,000. So it has an EV/EBITDA multiple of 5.0x.
You also own a restaurant nearby with incredibly similar characteristics to the previous restaurant. Your EBITDA for the same year was £40,000. You would use the multiple 5.0x with your EBITDA of £40,000 to calculate an Enterprise Value of £200,000.
This is an incredibly simplified version of the way investors calculate the values of businesses, but it can give rough overviews of yours vs. competitors financial situations. You can also use an EBITDA to calculate the value of a business without a viable comparison.
EV = Market Capitalisation + Total Debt - Cash
Market Capitalisation = Current stock price x number of shares
Debt = Total of all long-term and short-term debts
Cash = Liquid assets
You would take the EV of this equation and use the EV / EBITDA formula to calculate the multiple of that particular business.
While the EBITDA can give a general overview of your business finances, it may not produce an entirely nuanced figure. You can affect adjustments to your EBITDA by:
Reflecting the market rate in salaries, pensions and bonuses
Normalise the values of one-off unusual costs, expenses and income to be more accurate
Enlist expert R&D Tax Services which provides well needed tax relief
You can adjust EBITDA by calculating these costs. It’s not misleading, but rather represents a wholly more sophisticated financial picture of your company.
An EBITDA margin allows companies to be compared regardless of size by representing operating profits as a percentage of revenue. The EBITDA margin is:
EBITDA / Total Revenue = EBITDA Margin
A high EBITDA margin reveals low operating expenses in relation to the total revenue of that business. Investors prefer higher EBITDA margins as they reveal cost-effective, profitable companies. A change in your own company’s EBITDA can reveal the effectiveness of your cost-cutting techniques.
The final word on EBITDA
While there's no legal requirement for the calculation, EBITDA can be an invaluable tool that leads you to even more vital formulae.
From carrying out competitor analysis, and reviewing cost cutting techniques within your own business, EBITDA can give a read on the vital signs of your cash flow. By eliminating disparate tax treatments, capital costs and non-cash depreciation that may not represent future spending, it averages out companies' profitability fairly.
However, care must be taken when it comes to calculating EBITDA. An accounting professional should always be brought on board to accurately define costs, expenses and other criteria so that the value accurately reflects the state of a business.
That’s where we come in.
Our accounting services are second to none, it’s why we are the #1 finance partner for Startups. Our range of cost-effective CFO Services and R&D Tax Services guide all our partners through solid growth by providing clear finances. With our Tax team at the ready you can be sure your books are in the clear.
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