EBITDA—an acronym for “earnings before interest, taxation, depreciation and amortization”—is an accounting technique used to measure a company’s financial health and performance. EBITDA first came to prominent usage in the 1980s and is used today by many entrepreneurs as a tool to compare profitability between companies and industries.
Whereas typical income calculations measure profits simply by subtracting expenses from total revenue, EBITDA also accounts for the effect of taxes, assets and interest. As a result, business owners have more choice regarding what to include—and exclude—when calculating value.
You can determine your business’ EBITDA by calculating EBIT, or earnings before interest and taxes, and then adding back in depreciation and amortization. Unlike traditional cash expenses, depreciation and amortization apply to assets that were purchased at an earlier date. Furthermore, these values can change depending on how long those assets are expected to last.
Because EBITDA accounts for depreciation and amortization, it may offer a more insightful profit assessment for companies with a host of expensive assets.
Benefits of EBITDA
EBITDA offers various benefits over other metrics used to assess fiscal wellness. One of EBITDA’s biggest advantages is that it removes variables like financing and accounting decisions from the profitability equation. Because factors like tax and interest rates vary with the previous year’s acquisitions, these variables can alter net income in a way that’s misleading to investors.
For this reason, EBITDA proponents claim that the system provides a more accurate way of directly comparing companies with different levels of debt and even companies in different industries. Additionally, EBITDA allows investors to assess organizations with different capital structures and depreciation systems.
Many business owners use EBITDA to normalize company earnings. Referring to the process of eliminating non-recurring expenses, normalizing earnings allows companies to calculate future profit potential more accurately while presenting themselves in the best positive light to investors.
Here are a few EBITDA adjustments that businesses commonly use to improve valuation:
It’s no secret that the cost of getting a business off the ground is significant. As a new company, it’s important to normalize EBITDA by adding costs associated with the launch of your business. After all, startup costs are one-time expenses and will not affect your income potential moving forward.
The fact is that many new businesses lease space each month instead of purchasing it outright. One way of adjusting EBITDA upwards is to add rent costs above market value. Additionally, business owners can adjust EBITDA to reflect the true market value of goods and supplies.
In an effort to reduce their tax burden, businesses frequently categorize capital expenses as repairs. However, doing this can damage the overall valuation of your company. If your business underwent major maintenance this year, it’s important to adjust EBITDA by adding back in the cost of repairs.
One-Time Business Costs
Like repair and startup costs, professional fees are often one-time expenses that can have a significant effect on your company’s income. To create the most accurate and positive picture, companies should normalize EBITDA by adding back costs associated with settling a legal dispute, launching a special marketing project or obtaining a new license.
Despite the many benefits of using EBITDA to convey profits, the financial measure is not without its drawbacks. Here are a couple of the pitfalls associated with relying too heavily on EBITDA for investment decisions:
Because of the ease with which a company can normalize EBITDA, many investors feel that the metric is a poor way of measuring profit potential. By removing interest, taxes and depreciation, business owners can make their companies look better than they truly are. Additionally, companies may opt to list period expenses as assets, which can be depreciated. The end result is that companies appear fiscally healthy when they are actually less than profitable.
Because of this, should you decide to take your company public in the future, be aware that EBITDA cannot be used when computing GAAP-compliant (Generally Accepted Accounting Principles) statements. EBITDA, however, is frequently used as a tool for Non-GAAP reporting, which can be useful for contextualizing situations like those described earlier.
Cash Earning Confusion
Additionally, many people make the mistake of assuming that, in measuring profitability, EBITDA also represents cash earnings. However, the truth is that EBITDA fails to account for working capital, or the cash required to sustain daily operations, as well as costs associated with equipment repair.
Furthermore, many analysts feel that it’s misleading to discount costs associated with taxation and loan interest. After all, a company that neglects federal tax responsibilities or fails to make payments on loans is unlikely to remain in business for long.
To avoid falling victim to faulty or fraudulent accounting methods, investors should examine other metrics in addition to EBITDA before making a decision about where to spend their money. Some analysts prefer operating cash flow over EBITDA, as the former accounts for depreciation and amortization while including working-capital charges that use or supply cash to the business.
While EBITDA can be a useful tool for assessing revenue, it’s important to realize that it’s only one possible financial gauge. For the most complete view of a company’s profit potential, owners and investors should utilize more than one measure. The goal is to attain the most accurate view of a business’ financial health so you can make more informed decisions moving forward.