EBITDA is the earnings a business has before interest, tax, depreciation, and amortization, and is a financial metric used as an indicator of the financial performance and operational efficiency of the business. The measure is useful as it excludes the impact of non-operating expenses such as interest, taxes, depreciation and amortization.
EBITDA Calculation
EBITDA is calculated by adding back interest, taxes, depreciation, and amortization to the net income of the business. The formula for earnings before interest, taxes, depreciation, and amortization is as follows.
EBITDA = Net income + Interest + Taxes + Depreciation + Amortization
EBITDA vs. Net Income
As can be seen above EBITDA is not the same thing as net income. Net income is the total earnings of a business after taking into account all expenses. Net income is a measure of overall financial performance, while in contrast EBITDA focuses specifically on its operating performance.
The income statement below further illustrates the difference between the two terms.
| Sales | 100,000 |
| Cost of sales | 45,000 |
| Gross profit | 55,000 |
| Operating expenses | 30,000 |
| EBITDA | 25,000 |
| Depreciation | 10,000 |
| Interest | 5,000 |
| Earnings before tax | 10,000 |
| Tax | 2,000 |
| Net income | 8,000 |
Using Earnings Before Interest, Taxes, Depreciation, and Amortization
In the illustration above the line is drawn before interest, depreciation and tax. Consequently EBITDA effectively represents the income of the business before the effects of any capital investment (depreciation), before the effects of its method of financing activities (interest), and before the effect of any localized tax rates.
For this reason, earnings before interest, taxes, depreciation, and amortization is a good indicator for comparing businesses which have similar business models, but which have different financing structures, depreciation policies and tax systems.
EBITDA is also a useful indicator of cash flow from business operations and is the starting point for cash flow statements.
A multiple of earnings before interest, taxes, depreciation, and amortization is often used to support business valuations particularly when the business has net losses. For example is a business has EBITDA of 100,000 and the multiple for the type of industry it operates in is say 5, then an indication of the value of the business would be 5 x 100,000 = 500,000.
EBITDA Limitations
It is important to realize that EBITDA is not the same as cash flow. It is part of cash flow in that it represents the revenue after expenses, but it does not include cash required to fund working capital requirements (inventory, accounts receivable, and accounts payable), and to pay for capital expenditure, and such items as debt repayments.
In conclusion, earnings before interest, taxes, depreciation, and amortization is an important financial metric that provides insight into the operating performance of a business. However, it should not be used as the sole indicator of financial health, and should be considered in conjunction with other financial metrics, such as net income and cash flow.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.