There are many acronyms, ratios, and formulas that are vital to financial management with EBITDA standing out as one of the more important accounting principles. EBITDA stands for earnings before interest, tax, depreciation, and amortization. That might seem complex, but it’s simply a business gross profit before taxes, interest payments, and depreciation of tangible or intangible assets (i.e amortization). EBITDA is also interrelated among the three main financial statements which are the balance sheet, income statement, and cash flow statement.
EBITDA is impacted by revenues along with non-cash expenses from the income statement, assets on the balance sheet and operating activities on the cash flow statement. Other important concepts like working capital impact the EBITDA margin. This post will serve as a guide to EBITDA’s relationship to the other statements, when to use it, formula, different EBITDA scenarios, along with pros and cons.
What is EBITDA?
As mentioned above, EBITDA is earnings before interest, taxes, depreciation, and amortization which reflects a company’s gross profit margin. Many companies state they brought in impressive numbers like $1,000,000 per year, but that generally refers to revenue. Revenue might be impressive, but it’s nothing if the business is not profitable, meaning that its expenses exceed revenue. EBITDA is a good starting point to properly evaluate a company’s financial performance
IT (Interest and Taxes)
Some important factors to consider with EBITDA are the interest and tax payments. The interest section refers to companies that are mainly financed by debt, compared to equity. Companies obtain financing through debt which includes I.O.Us like bonds or issuing equity which is ownership in the company. Companies that receive venture-backed financing can give those firms equity percentages which allow them to be part owners. Also, issuing public stock or having an IPO is another way to be equity financed.
This applies to EBITDA as two companies that have identical metrics like revenue and cost of goods sold would have different net incomes based on financing decisions. The debt-financed company would have interest expenses that lower net income.
Taxes are an inevitable part of any business and can vary based on region. For example, businesses in states like Texas pay no state income tax, while those located in California pay the highest state tax rates in the nation. Two companies can have identical line items and ratios, but taxes can impact their EBITDA margin. This can help them quantify the impact of taxes on gross profit. In fact, no state income tax states are seeing huge influxes of businesses from high tax regions.
DA (Depreciation and Amortization)
Depreciation and Amortization expenses are important concepts that impact EBITDA. Depreciation refers to the diminishing value of a tangible asset over time. Like depreciation, amortization deals with assets losing value over time, but it refers to intangible assets like patents or trademarks. These items offer businesses important tax breaks and can alter net income based on the type of depreciation used. For instance, there are many depreciation decisions like MACRS, straight line and bonus depreciation that can alter these figures. Therefore, EBITDA can be used to gain valuable insights into depreciable assets.
Who should use EBITDA and when
EBITDA is used by the following people:
- Private Equity Firms: Private Equity Firms want to invest in private businesses with the goal of selling them at a profit. EBITDA is used to help these firms with private business valuation. This is very useful during merger & acquisitions or if a company is to be sold.
- Business Owners and Accountants: EBITDA allows business owners to look at the earnings before factors like taxes, interest, and depreciation. It can help them determine which factors have the biggest impact on their net income.
- Public Investors: Public investors use ratios like return on equity, price earnings ratio and the enterprise multiple to decide if they should invest in a company’s public stock. EBITDA helps them calculate the enterprise multiple, which can be found on major websites like yahoo finance. Experienced investors like to use great detail when selecting investments and can use EBITDA to compare companies in similar industries.
Fundamental EBITDA calculation and ratios
EBITDA is easy to calculate and can be found by taking:
Net Income + Interest + Taxes + Depreciation + Amortization = EBITDA
Operating income + Taxes + Depreciation + Amortization = EBITDA
EBITDA is generally found as a line item on the income statement. The income statement is one, if not, the most important financial statements for any sized business. Income statements show the business’s net profit by subtracting expenses from revenue. Individuals also use an income statement for personal finance needs, which is also called a budget.
Here is an example of an income statement that accounts for EBITDA:
Gross Profit: $80,000
Interest Payment: $2,000
Depreciation and Amortization: $10,000
Net Profit before Tax: $48,000
Taxes at 30%: $14,400
Net Profit: $33,600
EBITDA as shown by highlighted figures: $60,000
This mock income statement shows the relationship between EBITDA and the income statement. It also shows how net profit and EBITDA can significantly vary.
EV/EBITDA or Enterprise Multiple
EBITDA is also used to calculate the EV/EBITDA multiple, which is used in private equity. This ratio is pretty simple as it takes the enterprise value and divides it by the EBITDA. Enterprise value is a measurement of a company’s total value. This figure not only includes the market capitalization (total outstanding shares x market price) but also cash from the balance sheet, long and short term debt. Enterprise value can be seen as the company’s takeover price if it were to be bought.
This ratio is used to compare companies in similar industries and if they are under or overvalued. Investors should be aware of comparing companies in similar industries as comparing companies in different industries have vastly different results. It’s better to have a lower EV/EBITDA multiple as this shows a company is undervalued.
The P/E ratio or Price Earnings ratio is similar to the enterprise multiple. It’s also used to see if a company is under or overvalued. The P/E ratio is calculated by dividing the stock price by the earnings per share or EPS. A P/E ratio is also referred to as the amount an investor would pay for a dollar of that company’s profit. The EV/EBITDA ratio paints a clearer picture because its more helpful for comparing businesses with different financial leverage strategies along with depreciation schedules.
EBITDA margin ratio
The EBITDA margin ratio is relatively similar to the net profit margin ratio as both reflect a percentage of earnings compared to revenue. Calculate the EBITDA margin ratio using this simple equation: EBITDA/Revenue. This metric is important because it shows businesses how efficient their operating cash flow is.
For instance, Company X has an EBITDA of $50,000 and revenue of $200,000. Company Y has an EBITDA $60,000 and revenue of $300,000. The EBITDA margin would be 25% for Company X and 20% for Company Y. Most people would assume that company Y is more attractive since it has higher EBITDA and revenue. Despite this, Company X could be more attractive since it uses its cash flow more efficiently due to its higher EBITDA margin of 25%.
EBITDA and its relationship to the balance sheet and cash flow statement
EBITDA is pretty easy to calculate when using the income statement. After all, it just requires adding back interest, depreciation, amortization, and taxes. Besides the income statement, EBITDA can also be impacted by the balance statement and cash flows statement.
For example, depreciation and amortization are found on the balance sheet and cash flow statement. These items are accounted for in the property & equipment line item of the balance sheet and the operating area of the cash flow statement. Investments in property and equipment can be found under the investing activities of the cash flow statement, which flow back to the balance sheet. All these activities impact net income and other aspects of the EBITDA equation.
Different variations of EBITDA
EBITDA has many variations with one of the most common ones being EBIT, which stands for earnings before interest and taxes. This metric can be helpful, especially if a company doesn’t have any intangible assets. EBIT is also helpful for capital intensive industries like oil, gas, and resources. Since these industries have many depreciable assets, EBIT could be a better alternative.
EBIT is the main alternative to EBITDA, but some lesser-known options include:
- EBIAT (Earnings Before Interest After Taxes)
- EBID (Earnings Before Interest and Depreciation)
- EBIDA (Earnings Before Interest, Depreciation, and Amortization)
- EBITDAX (Earnings Before Interest, Tax, Depreciation, Amortization, and Exploration)
- EBITDAR (Earnings Before Interest, Tax, Depreciation, Amortization and Restructuring/Rent Costs)
- EBITDARM (Earnings Before Interest, Tax, Depreciation, Amortization, Rent and Management Fees)
These variations are generally used by specific industries like the EBITDARM being used in real estate. Rents received and management fees play a large role in both commercial and residential real estate industries. Therefore, some analysts like to see the entire picture prior to these unique real estate line items.
Capital Expenditures (capex) are similar to depreciation and refers to when a business makes purchases to roll out a new product line or expand an existing operation. Conversely, depreciation refers to items that were bought in the past and capital expenditures are found under the depreciation category.
Depreciation doesn’t perfectly correspond to capital expenditures, but it’s a more predictable version over the long term. People that support EBIT believe that depreciation is an accurate representation of capex, which is required to run the business. Therefore it’s wise to look at earnings after depreciation.
Conversely, capital expenditures can be very inconsistent and are discretionary. Capex is meant for growth expenditures while depreciation maintains the business. EBITDA supporters feel that capex is discretionary and should be excluded.
Pros of EBITDA
- Being used to evaluate unprofitable companies. Some metrics don’t tell the entire scenario, but EBITDA can pinpoint areas that can help the business become profitable. It can help businesses break down details like financing arrangements and businesses can alter these to maximize their profit. Business owners can also use EBITDA to compare themselves against there competitors. Private Equity firms can use EBITDA for valuation purposes and this can influence mergers and acquisitions.
- Acting as a building block for the popular enterprise multiple, coverage ratio, and margin formula. The enterprise multiple is similar to the price-earnings ratio, but it takes debts and cash equivalents into account. EBITDA serves as a crucial part of this ratio, which makes it easier for valuation purposes.
- Making it easier to calculate a company’s solvency or the ability for it to pay its long term debts. This can be accomplished by using the debt coverage ratio which is found by dividing the EBITDA by the required debt payments. The debt coverage ratio makes it simple to see how long a company can pay down its debts without additional financing.
Cons of EBITDA
- Not recognized by GAAP or IFRS. The GAAP, or generally accepted accounting principles is a board that regulates accounting standards in the US and the IFRS regulates international accounting standards. Some people like the famous investor, Warren Buffet are skeptical of this figure as it shows the company not paying any interest or taxes. It also reflects assets not losing true value over time (i.e depreciation or amortization). Therefore, it’s wise to consider other items like capital expenditures, net income, and cash flow.
- Since it doesn’t factor in cash flow, this means it doesn’t account for changes in working capital. Working capital is simply the difference between a company’s current assets and current liabilities. It’s a gold standard that is used to assess if a company can pay its short term obligations.
- Related to this, EBITDA doesn’t show how easily a business could convert assets to cash. This is also referred to as liquidity with some assets like account receivables being more liquid than others (i.e real estate).
Unfortunately, EBITDA is susceptible to fraud as it’s not regulated by GAAP nor IFRS. Unscrupulous companies can manipulate figures like depreciation and interest to artificially inflate this figure.
For instance, WorldCom was a “successful” telecom company back in the 1990s that used EBITDA fraudulently. WorldCom had a negative EBITDA and decided to change regular period expenses to assets in order to depreciate them. This underhanded move removed the expense and increased depreciation, which acted as a false sense of profitability.
This protected WorldCom’s stock, but things eventually caught up with them, which resulted in its bankruptcy. WorldCom is also known for being one of the biggest accounting scandals in the US and is at the same level as the Enron scam. These scams also led to the creation of Sarbannes Oaxley or SOX back in 2002. SOX was created to enforce stricter accounting rules and prevent massive frauds.
Simple ways to improve EBITDA
EBITDA can be very influential towards businesses and small increases of EBITDA by just 50 basis points (bps) can greatly help a company’s bottom line. BPS represent a one-hundredth of a percent with 50 basis points being half a percent (0.50%). So a company that has an EBITDA of $10,000,000 with a 50 basis point increase would be worth an additional $50,000. This $50,000 can be used to reinvest in the business, train employees and pay down debts.
The first simple way to improve EBITDA is to maintain prices, as frequent discounts reduce EBITDA. Businesses should emphasize selling customers on the value of their products or services, not price. They should also find other ways to cut costs like negotiating financing terms or re-evaluating other fixed costs.
Proper inventory and working capital management
Next, businesses should effectively manage inventory and working capital. Inventory is an important part of many businesses, but too much of it can be a bad thing. For instance, businesses that have inventory sitting idle for long periods of time lose money by not collecting revenue.
Some inventory can be hard to liquidate or convert to cash. Therefore, some businesses might have to sell inventory at a loss just to get rid of it. Conversely, businesses need to constantly monitor inventory that has a high turnover, so they can always make sales. Failing to do this will anger customers and cause lost revenue.
Finding the right balance between sales, manufacturing, and the supply chain will help small businesses improve their EBITDA. Proper management will keep fixed costs low, avoid any opportunity costs via lost sales, improve cash flow which positively impacts EBITDA
Monitor travel, meals, and entertainment deductions
The third way businesses can improve their EBITDA is to pay close attention to their travel and entertainment budgets. While entertainment and meal deductions have changed, self-employed individuals still have deductions for qualified opportunities. For example, businesses can deduct 50% of each client meal and this IRS publication goes into more detail regarding this.
These costs might have tax advantages, but they’re still viewed as expenses on the financial statements. Therefore, it’s wise to consider the purpose behind each client meal or trip. Business meals, travel, and entertainment can be extremely useful if they help increase revenue by signing clients.
On the other hand, they can be a waste of time if they don’t drive revenue and that time could have been used on more useful tasks. One simple way to maximize client meetings is to use a virtual conferencing platform like Skype or Zoom. This could be more effective than spending money on flights and/or hotel rooms. Responsible management of these deductions will greatly maximize EBITDA in the long term.
EBITDA or earnings before interest, tax, depreciation, and amortization is a crucial accounting figure that has an important relationship to the main financial statements.
- It also has important connections to concepts like capital expenditures and working capital.
- EBITDA can be good in certain situations but it can be wise to use a different approach in other situations.
- EBITDA can be a great way to measure the difference between gross and net profit, which can tell if a business is truly profitable.
- Lastly, it can help firms pinpoint weaknesses and maximize resources.
Disclaimer: This post isn’t tax law advice, but education. Consult a CPA or tax adviser for advice.