EBITDA: what is it and how do you calculate EBITDA?

Canary Wharf London cityscape at night with HSBC building
Rebecca Cattlin
By :  ,  Former Senior Financial Writer

EBITDA is a metric that’s used by investors to get insights into the profitability of a company. Discover what EBITDA stands for and how the different EBITDA formulas are used. 

 

What is EBITDA?

EBITDA is the abbreviation of earnings before interest, taxes, depreciation and amortisation. It’s an alternative measure of profitability to the standard net income or cash flow metrics – as it gives a measure of a company’s cash profits once all costs and taxes are removed.

Some public companies will highlight their EBITDA figure during earnings reports, but it’s not a generally accepted accounting principle (GAAP). So, any company that does list an EBITDA figure will also have to report a net income figure.

Sometimes a company will choose to report an adjusted EBITDA figure instead, which excludes additional costs associated with stock-based compensation.

 

Depreciation meaning in EBITDA

Depreciation refers to the declining cost of a tangible or physical asset during its lifespan. It represents how much of an asset’s value has been used up within a given year.

Amortisation, on the other hand, is the expense incurred on intangible assets, such as patents and copyrights, that only have a limited useful life before they expire. Depreciation and amortisation are often grouped together as D&A. 

Because of the declining value of assets, a company’s operating income might be different to the figure that analysts think it should be, as these costs eat away at the bottom line. That’s why EBITDA removes D&A from income, as the equipment and so on are vital to the business operation, but its deterioration is out of the company’s control.

Learn more about amortisation vs depreciation

 

What is EBITDA used for?

EBITDA is used to remove the costs that are not necessarily related to the business’s core operations or that are a result of accounting strategies.

For example, changes in tax liabilities and interest rates don’t have any bearing on the operational performance of a company – as these factors are outside of the company’s hands – but they will impact the bottom line.

By excluding these figures, the focus is kept on the profits a company generates each year and can be used to provide a more consistent comparison from year to year.

EBITDA is also commonly used to compare two companies within a similar industry to get an idea of whether one is over or undervalued in relation to the other. The companies have to be within a similar industry for it to work.

 

Criticisms of EBITDA

Critics of EBITDA argue that it cannot be a meaningful measure of a company’s performance, as depreciation and other capital costs are crucial to understanding the health of a business.

For example, companies from asset-heavy industries that will have a lot of equipment and property could use EBITDA as a way of shifting focus away from their net income figure. This would present a more profitable business than looking at the company’s bottom line.

It’s important to keep an eye out for a company that suddenly starts focusing on EBITDA instead of other figures that it previously highlighted. Companies that are borrowing heavily or experiencing an increase in costs are likely using EBITDA to distract investors.

Another criticism of the metric is that it’s not standardised. As it’s a non-GAAP figure, companies can use different versions of the EBITDA calculation to make their profits look more appealing to investors.

 

How to calculate EBITDA

The basic calculation for EBITDA starts with the net income figure, and then adds interest, taxes, and depreciation & amortisation back to that figure. The EBITDA formula is:

EBITDA = net income + taxes + interest expense + depreciation & amortisation

Let's look at an example earnings report to see that calculation in action. Here, you'd be taking the net income figure and adding 'total taxes', 'interest' and 'depreciation' back in to give you the EBITDA figure listed at the bottom. 

 

All figures in USD millions Year 1 Year 2 Year 3
Revenue 90,000 100,000 110,000
Cost of goods sold 45,000 50,000 55,000
Gross profit 45,000 50,000 55,000
Depreciation 3,000 3,100 3,500
SG&A 30,000 31,000 34,000
Interest 2,000 2,200 2,500
Income before taxes 10,000 13,700 15,000
Total taxes 4,000 4,500 5,000
Net income 6,000 9,200 10,000
EBITDA 15,000 19,000 21,000

 

However, there is another formula that uses operating income as the basis of the formula, which already has depreciation deducted but not taxes or interest. That formula would be as follows:

EBITDA = operating income + depreciation & amortisation

EBITDA margin

Some companies will take these calculations one step further to look at EBITDA margin. This is a figure that shows how much operating expenses are eating into a company’s profits.

The EBITDA margin is calculated by taking the company’s EBITDA and dividing it by its total revenue. On our example income statement above, for year 1, the EBITDA margin would be:

15,000 ÷ 90,000 = 16%

Once you can work out the EBTIDA of a company, the next step is working out whether it’s indicating a company is healthy or not.

 

What is a good EBITDA?

In general, the higher the EBITDA, the less risky a company is considered. An EBITDA margin over 10 is considered good. However, it’s all comparative because a positive EBITDA doesn’t automatically mean that a business has high profitability.

If an EBITDA margin is lower than 10 or negative, it shows the company has poor cash flow and might be expected to underperform against competitors.

 

EBITDA vs gross profit

EBITDA and gross profit are both ways of analysing how profitable a company is, after removing certain costs.

Gross profit is the income a company earns after it has deducted the direct costs of production or operation. It measures how well a company is doing as a direct result of its labour and materials.

Gross profit is calculated as:

Gross profit = revenue – the cost of goods sold

The difference between EBITDA and gross profit lies in the costs they remove. Gross profit only looks at the costs associated with production, it doesn’t look at any of the business’s day-to-day running costs, such as office rent, salaries and so on.

Meanwhile, EBITDA takes those into consideration but doesn’t include expenses that are outside of a company’s control, such as tax and deprecation.

 

EBITDA vs EBIT

Earnings before interest and taxes (EBIT) is a company’s net income with income tax expense and tax expenses excluded. It’s primarily used to analyse a company’s core operations and how profitable they are.

Net income includes interest and tax already, so all you’re doing to calculate EBIT is:

EBIT = net income + interest + tax

Unlike EBITDA, EBIT does include the non-cash expenses of deprecation and amortisation. 

Most businesses choose to use EBITDA over EBIT, as it gives them a larger result and makes them look more profitable. But also, analysts tend to argue it does also provide more insight into the cash position of the business.

In reality, both EBIT and EBITDA are useful figures, but shouldn’t be taken in isolation and at the expense of looking at a company’s actual bottom line.

Learn about financial ratio analysis.

 

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