EBITDA meaning: What it is and when it's used

A company's earnings before interest, taxes, depreciation and amortization (EBITDA) is one way to measure profitability and financial performance.

EBITDA can be helpful for analyzing organizations over time and when comparing different businesses from the same industry because it removes variables that the companies might not be able to control, such as their tax rates. For small business owners, it can also help you understand whether your business is making money from its core operations.

Investors, financial analysts and lenders also may consider a company's EBITDA, along with other metrics, when deciding whether to invest in or lend money to the company.

What is EBITDA?

Companies may report their EBITDA during a specific period, such as a quarter or year. The different components that go into the calculation are:

• Earnings: How much the company earned after operating expenses, which is also called net income
• Interest: How much the company paid in financing costs, such as interest on loans and lines of credit
• Taxes: How much the company paid in local, state and federal tax payments
• Depreciation: The reduction in the value of the company's fixed assets, such as its inventory, vehicles and office equipment.
• Amortization: The reduction in value from the company's intangible assets, such as its trademarks, software and patents.

Consider a company's depreciation and amortization on non-cash costs, for example. Depreciation spreads the cost of fixed assets over their useful life, which can be important for accounting and tax purposes.

Say a company purchases a piece of equipment for $115,000, the equipment lasts for 10 years, and it can be salvaged for $15,000 at the end. It can depreciate $10,000 each year to reduce its tax bill, but the company isn't actually paying anyone the $10,000 annually.

How is EBITDA calculated?

Companies might choose to report their EBITDA in quarterly and annual reports. You can also calculate a company's EBITDA using information from its financial statements. For example, you can find the earnings, taxes and interest on the income statement, and depreciation and amortization on the cash flow statements.

The EBITDA formula is:

EBITDA = earnings + interest + taxes + depreciation + amortization

A company's earnings is its revenue minus cost of goods sold (COGS), operating expenses, interest and taxes. COGS includes the direct cash expenses for creating and delivering a product or service, such as labor and materials. The operating expenses are the indirect costs, such as rent, utilities and marketing.

Say a company reports the following for the year:

• Net income: $200,000
• Interest: $50,000
• Taxes: $30,000
• Depreciation: $40,000
• Amortization: $20,000

Its EBITDA is $200,000 + $50,000 + $30,000 + $40,000 + $20,000 = $340,000

What EBITDA is used for

Business owners, investors, financial analysts and lenders may use EBITDA to better understand a company's financial situation. It can be helpful when you need to:

• Measure core profitability: You can use EBITDA to measure a business's core profitability or losses because it doesn't include costs that aren't directly tied to its day-to-day operations.
• Understand operational performance: EBITDA can help you understand how well a company does at turning top-line revenue into bottom-line profit. As a result, it might offer clarity into companies with a lot of depreciation or interest payments.
• Value investment opportunities: EBITDA can be useful when you want to compare companies that are in the same industry but have different accounting policies, debt levels or tax bases. For example, it can be helpful if you're considering options for mergers or acquisitions, or if you have to recommend investments.
• Approximate cash flow: EBITDA isn't the same as cash flow (how much money flows into and out of a business during a given period), but it can give you a quick understanding of how much money the company might have to cover additional expenses.

How banks use EBITDA

Banks can use EBITDA to gauge the health of businesses that apply for loans or lines of credit, and to monitor businesses that have an outstanding balance with the bank.

For example, a bank might use your business's EBITDA during:

• Loan underwriting: When you apply for credit, the bank might review your company's credit history, credit score, financial statements, collateral and general market conditions to determine if you qualify for a loan or line of credit. Banks might look at the company's debt-service coverage ratio (DSCR) to understand how easy it is for the company to cover its loan interest and principal payments based on its free cash flow. The DSCR formula is often (EBITDA - cash taxes) / (interest + principal), and a higher DSCR is best. Similarly, the debt-to-EBITDA ratio (net debt / EBITDA) offers a broader measure of a company's cash flow relative to its total outstanding debt.
• Credit-risk analysis: Banks also consider how risky your business is when determining how much to lend you and the interest rate to charge. A low EBITDA, low DSCR or high debt-to-EBITDA ratio might indicate a business is more likely to miss a payment in the future, which could lead to a lower loan limit and higher interest rate.
• Loan covenant monitoring: Banks may require covenants for business loans, or rules that the borrower needs to follow to avoid defaulting. For example, some covenants may require minimum EBITDA amounts each quarter. But the covenants may use an adjusted EBITDA by adding or subtracting major one-time costs, and banks and businesses might negotiate what to include or exclude in the calculations.

Banks and investors may also derive other metrics from EBITDA. For example, the EBITDA margin — (EBITDA / revenue) x 100 — measures a company's operating profit relative to its revenue. It can be helpful when you want to understand how efficient companies are, especially if you're comparing different companies from the same industry.

What else to consider when using EBITDA

Although EBITDA can be helpful in certain situations, it's generally important to consider multiple financial metrics to get a complete picture of a company's financial health. Consider the following when you want to use EBITDA:

• Calculations can differ: Neither the Generally Accepted Accounting Principles (GAAP) nor the International Financial Reporting Standards (IFRS) use EBITDA. The lack of standardization means companies can adjust what goes into their EBITDA calculation. Public companies have to call this out by reporting an "adjusted EBITDA." Private companies might not have the same requirements, and adjusted EBITDAs could potentially mislead investors or lenders.
• It doesn't offer a complete financial picture: Generally, you use EBITDA alongside other financial metrics to get a complete picture of a company's financial situation. After all, focusing on core metrics like EBITDA can be useful, but interest and taxes are real costs that the company needs to plan for and pay. Depreciation and amortization are equally important, even if they don't directly affect cash flow for the quarter or year.
• Averages may vary by industry: A "good" EBITDA can vary by industry, company size and company stage. If you want to gauge a company's financial health, try to compare its EBITDA to industry averages and monitor changes in its EBITDA over time.
• It ignores capital expenditures: EBITDA doesn't include how much you'll have to reinvest in fixed and intangible assets, which could give you a distorted view of your company's financial health.

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Your company's EBITDA can help you track its financial health, measure performance over time, or if you're looking for financing. If you're ready to take the next step, Citizens is here to help answer your questions and explain your options. Learn more about Citizens' hassle-free business loans and lines of credit.

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