EBITDA: Definition, formula + importance for small businesses

EBITDA is a powerful tool that helps you understand your company's financial performance by focusing on its operational efficiency. As a business owner, you're likely facing a mountain of data every day. It can be overwhelming to sift through it all and determine which numbers truly matter. 

But understanding your profitability is critical—especially since 72% of business owners plan to invest in expanding their business this year, according to QuickBooks’ Entrepreneurship in 2025 report.

In this guide, we'll break down EBITDA step by step, exploring its calculation, interpretation, and significance. You'll learn how to use EBITDA to assess your company's financial health, compare it to industry benchmarks, and make informed decisions about your future. 

Whether you're a seasoned entrepreneur or just starting out, understanding EBITDA can empower you to navigate the complexities of business finance and drive your company toward success.

Jump to:

• EBITDA meaning
• How to calculate EBITDA
• Understanding the EBITDA formula
• Example of EBITDA
• What is a good EBITDA margin?
• Why is EBITDA so important?
• How EBITDA and cash flow differ
• EBITDA vs. EBIT vs. EBT
• Limitations of EBITDA
• Streamline your accounting and save time

How to calculate EBITDA

EBITDA measures a company’s profitability that focuses on its core operating performance, excluding the impact of financing decisions, tax policies, and accounting choices related to asset depreciation and amortization. It stands for earnings before interest, taxes, depreciation, and amortization. 

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

Key elements of the EBITDA formula

EBITDA is a key metric that helps us understand a company's core operational profitability by stripping away the effects of financing, taxes, and noncash expenses. To understand it, we need to examine the components of a multi-step income statement.

Net income

Net income is the culmination of all revenue and expenses, representing the company's final profit after accounting for all costs. It's the bedrock of financial reporting and the starting point for calculating EBITDA. 

However, because EBITDA aims to isolate core operational performance, we need to adjust net income by adding certain expenses. Net income reflects the company's ability to generate profit after all obligations are met, including financing and taxes, which EBITDA intentionally excludes.

Interest expense

Interest expense represents the cost of borrowing money, a fundamental aspect of many businesses' financial strategies. It's the expense a company incurs for its debt obligations, whether from loans, bonds, or other forms of financing. 

By adding back interest expense, EBITDA removes the influence of a company's capital structure, allowing for a more level comparison with businesses that may have different debt levels or financing strategies. This adjustment helps reveal the profitability of the company's core operations, independent of its financing choices.

Tax expense

Tax expense reflects the income taxes a company owes to the government, a necessary part of doing business. However, tax rates and regulations vary significantly across jurisdictions and time periods, making direct profitability comparisons challenging. 

By adding back tax expense, EBITDA neutralizes the impact of these variations, providing a more consistent measure of operational performance. This adjustment allows business owners to focus on the efficiency of their operations rather than the complexities of tax law.

Depreciation and amortization expense

Depreciation and amortization expenses are noncash expenses that reflect the gradual decrease in value of a company's assets. Depreciation applies to tangible assets (like machinery or equipment), while amortization applies to intangible assets (like patents or copyrights). These expenses are accounting entries that allocate the cost of assets over their useful life rather than actual cash outflows. 

EBITDA eliminates the influence of accounting choices related to asset depreciation and amortization by adding them back, providing a clearer picture of the company's cash-generating potential from its core operations. This adjustment is particularly relevant for capital-intensive businesses with significant investments in long-term assets.

Example of EBITDA

Let's walk through a practical example of calculating EBITDA using an income statement. Below is the income statement for Premier Manufacturing.

Now, let's calculate the EBITDA for Premier Manufacturing. From the income statement, we can identify the necessary components:

• Net income: $38,200
• Interest expense: $2,000 
• Tax expense: $9,000
• Depreciation expense: $3,000 
• Amortization expense: $4,000 

Plugging these values into the EBITDA formula:

EBITDA = $38,200 + $2,000 + $9,000 + $3,000 + $4,000 = $56,200

As you can see, Premier Manufacturing's EBITDA is $56,200. This metric provides valuable insight into the company's operational performance, excluding the impact of financing decisions, tax policies, and noncash expenses.

What is a good EBITDA margin?

The EBITDA margin is EBITDA divided by revenue. Most companies do not include a gain on sale as revenue if the gain is a nonoperating income category. In Premier’s case, the gain on a machinery sale is not revenue. The only revenue category is $520,000 in sales.

Premier’s EBITDA margin is $56,200 divided by $520,000 revenue, or 10.8%. So Premier earns nearly 11¢ for every dollar of revenue.

To determine if an EBITDA balance is attractive, consider a company’s EBITDA over time and how the balance compares with industry benchmarks. If the balance increases yearly, the business is increasing sales and controlling costs. The trend makes the company more valuable.

Potential buyers use EBITDA to compute the purchase price because the owner can distribute earnings as dividends. If two companies generate sales of $3 million a year, the company with the higher EBITDA is more valuable.

How is EBITDA useful to businesses?

Those who use the EBITDA formula prefer to analyze a company’s performance based on day-to-day business operations. They disregard debt (interest costs), taxes, depreciation, and amortization. Premier’s business operations include manufacturing, purchasing raw materials, paying employees, and billing customers. If you’re using EBITDA, you need to understand how debt and taxes can differ between companies.

Identifies debt management inefficiencies

Capital structure refers to the percentage of equity and debt a company uses to finance its operations. Factors such as a company's age, industry, and asset requirements can influence its capital structure. Startups and online businesses typically require less capital than established companies and those in asset-heavy industries.

Pay close attention to the dollar amount of debt added back to earnings. High levels of debt generate more interest expense and require more cash for principal and interest payments.

Highlights business profitability outside of taxes

Two companies in the same industry that generate similar profits can have very different tax expenses. The tax code is complex, and dozens of factors impact a company’s tax expense in a particular year.

For example, a tax carry-forward allows businesses to reduce current year earnings with losses incurred in past years. If a business uses a tax carry-forward, it lowers the tax expense in the current year. When the lower tax expense is added back to earnings, the current year EBITDA is lower.

EBITDA vs. cash flow

Generally accepted accounting principles (GAAP) require companies to use accrual accounting to generate financial statements. Using the accrual method can generate large differences between EBITDA and cash flow.

The accrual method requires businesses to recognize revenue when they earn it and expenses when they incur revenue. Businesses don’t use cash inflows and outflows to determine revenue, expenses, or net income.

Assume that Premier purchases $1,000 in materials in January and pays $2,000 in labor costs in February to produce a piece of furniture. They finish the product and deliver it in early March for $4,200.

Accrual accounting requires Premier to post the $4,200 in revenue and $3,000 in material and labor costs in March. Premier incurs other costs, including shipping, but the profit on the sale was $700.

This approach matches expenses and revenue in the same period and presents a more accurate picture of the profit.

If you use the accrual basis to calculate net income, EBITDA will not reveal information about cash inflows and outflows.

The furniture sale example didn’t explain when Premier paid cash for the material and labor costs. Nor did it explain when the customer paid cash for the purchase. Premier earned a $700 profit, but the data provided didn’t explain the company’s cash inflows and outflows.

EBITDA is a useful tool for analyzing profit but not cash flows. To understand a company’s cash position, review the statement of cash flows.

EBITDA vs. EBIT vs. EBT

While EBITDA is a widely used metric for assessing a company's profitability, it's not the only one. As we've explored, EBITDA provides a valuable view of core operational performance. However, some other measures offer different perspectives on profitability, each with its own unique focus. Two such measures are EBIT (Earnings Before Interest and Taxes) and EBT (Earnings Before Taxes). Let's delve into each of these.

EBIT

EBIT, which stands for Earnings Before Interest and Taxes, is also known as operating income. It focuses on the profit a company generates from its core operations, excluding the impact of financing costs (interest expense) and income taxes. 

Unlike EBITDA, however, EBIT includes depreciation and amortization expenses. This means EBIT reflects the company's operating profit after accounting for the costs associated with the wear and tear of its assets.

The formula for calculating EBIT is:

EBIT = Revenue - Cost of Goods Sold - Operating Expenses (including Depreciation and Amortization)

EBIT is a useful metric for evaluating a company's operational efficiency and profitability before considering the effects of its capital structure (debt) and tax burden. Now, let's move on to EBT.

EBT

EBT, or Earnings Before Taxes, is sometimes called pre-tax income. This metric shows a company's profitability before income taxes are deducted. Unlike EBIT and EBITDA, EBT includes both interest expense and depreciation/amortization. This makes EBT useful for understanding a company's overall profitability, including the impact of financing decisions, but before considering the complexities of tax regulations.

The formula for EBT is straightforward:

EBT = Revenue - Cost of Goods Sold - Operating Expenses 

EBIT and EBT, when considered alongside EBITDA, offer a more well-rounded understanding of a company's financial performance. Each metric brings unique insights, and their combined analysis provides a clearer picture of profitability.

Limitations of EBITDA

While EBITDA is a valuable tool for analyzing profitability, it's crucial to be aware of its limitations. Relying solely on EBITDA without considering other financial metrics can lead to an incomplete or misleading picture of a company's financial health. Here are some key limitations to keep in mind:

• Ignores capital expenditures: EBITDA doesn't account for the cash required for capital expenditures (CAPEX), which are investments in fixed assets like property, plant, and equipment. These expenditures are essential for maintaining and growing a business—ignoring them can overstate a company's true profitability.
• Can be manipulated: Since EBITDA is a non-GAAP measure, it doesn't adhere to the same strict accounting standards as GAAP metrics. This leaves room for manipulation, as companies may exclude certain expenses or make aggressive accounting choices to inflate EBITDA.
• Doesn't reflect overall financial health: EBITDA focuses solely on operating profitability and doesn't consider factors like debt levels, working capital requirements, or cash flow. A company with high EBITDA might still face financial difficulties if it has excessive debt or struggles to manage its cash flow effectively.
• Oversimplifies cash flow: While businesses sometimes use EBITDA as a proxy for cash flow, it doesn't provide a complete picture. EBITDA doesn't account for changes in working capital (e.g., accounts receivable, inventory) or other cash inflows and outflows that can significantly impact a company's cash position.

Therefore, it's helpful to use EBITDA with other financial metrics and analyses to gain a comprehensive understanding of a company's financial performance and overall health.

Streamline your accounting and save time

When you produce your financial statements each month and year, generate the EBITDA balance. Compare the balance to past periods and determine if the trend is increasing or decreasing. Compare your performance to other businesses in your industry. Accounting software, like QuickBooks, can help you learn more about your business finances and perform more detailed analyses in less time.