Running your own business can leave you overwhelmed with information, so you need useful metrics to make decisions. Many business owners use EBITDA and the EBITDA margin—calculations that take information from the income statement. Use this guide as a starting point to help you decide if you’ll use the EBITDA calculation. You’ll also want to understand the relationship between debt, taxes, cash flow, and a company’s profitability.
What is EBITDA?
EBITDA is “earnings before interest, taxes, depreciation, and amortization.” This calculation is a measure of a company’s profits. But it’s important to note that EBITDA is different from net income (or net profit).
Depreciation expenses post to recognize the decline in value of capital expenditures, including vehicles, machinery, and equipment. Amortization expenses record when intangible assets produce revenue. The bottom line is that every asset’s value reclassifies into non-cash expenses over time.
A company’s net income is total revenue minus expenses. EBITDA will add back four expense categories to the net income calculation. If a business generates a profit, net income will be less than the EBITDA balance because net income includes more expenses.
Calculating EBITDA can provide several reporting insights and help you make informed decisions about a company’s earnings. You can compare your financial performance to similar companies and assess the profitability of core operations.
Understanding the EBITDA formula
To understand EBITDA, review the multi-step income statement formula: revenue minus the cost of sales and operating expenses plus non-operating income.
The income statement and cash flow statement cover a period of time, but a balance sheet generates on a specific date. All three reports address financial health and a company’s operating performance.
To explain the EBITDA formula, take a look at Premier Manufacturing’s multi-step income statement.
The formula includes the following components:
- The cost of goods sold includes material and labor costs directly related to the product or services sold. Sales minus the cost of sales equals gross profit.
- Operating expenses include a product’s indirect costs, including amortization, depreciation, and interest expense.
- Gross profit minus operating expenses equals operating income. Premier has both non-operating income and expenses. The net amount ($700) is added to operating income to determine income before taxes.
- Income before taxes minus income tax expense equals net income.
Operating income is generated from day-to-day business operations, while non-operating income is unusual or infrequent. Premier is a manufacturer and not an equipment retailer. So the income and expense from the machine sale posts to non-operating income.
Some business owners use EBIT, or earnings before interest and taxes, to assess a company’s ability to produce an operating profit. However, EBITDA is the more common metric to measure a company’s financial performance.
How to calculate EBITDA
Multi-step income statements may vary slightly, but the EBITDA formula’s components should be easy to find. Interest, depreciation, and amortization expenses are operating expenses. The tax expense calculation is at the end of the statement.
The EBITDA formula follows:
Net income + interest expense + tax expense + depreciation expense + amortization expense = EBITDA
Using the formula, we find that Premier’s 2020 EBITDA balance is $56,200.