Overview
In this article, we will cover how to calculate EBITDA. Before going in detail, let’s go through the overview and basis definition of EBIDTA.
Basically, there are many ratios and statistics that investors use to check whether investing in a particular business is profitable for them. These ratios can tell the investor different information related to the performance of the business. Some of these ratios rely on historical data obtained from the financial statements of a business while others rely on forecasted information. Ratios that use historical statistics state to the investor regarding the past performances of the business. This allows the investor to forecast or extrapolate the performance of the business in the future. These forecasted statistics are then used for ratios that are forward-looking.
Investors use many key ratios to evaluate the performance of businesses they are considering investing in. Some of these ratios may be readily available such as the Earnings Per Share (EPS) ratio, which is a calculation of the total earnings of a company per one share issued. Other ratios such as the P/E ratio, which is a comparison of the price of a share of a company to its earnings, may need to be calculated using information from other sources. Another key statistic that tells investors about the operational efficiency of a company is known as the EBITDA. For businesses to attract investors, they must also understand what the ratio means.
What is EBITDA?
The EBITDA (short for Earnings Before Interest Taxes Depreciation and Amortization) is a useful statistic for both business and investors. It is an indicator of the short-term operating efficiency of a business. Investors use it to evaluate the performance of the business without considering the implications of the financing and other unrelated decisions of the business. In other terms, it allows investors to calculate the performance of business without considering items outside the scope of the operations of a business.
It can also be used by investors as a comparison tool to compare the efficiency of a business with other similar businesses. It allows the investor to make better comparisons of the earnings of the business. This is mainly because it allows investors to check the performances of two businesses without comparing items that are not within the operating scope of these businesses. These items include non-cash items which are interests, taxes, depreciation, and amortization. Using it as a comparison tool can allow for more objective calculation of the performance of businesses as compared to using profits of the business.
To understand it even better, investors and businesses can break it down into its different parts.
Earnings – These are the earnings of a business for a specific period. The earnings of a business can be obtained in the form of net profit from the Statement of Profit or Loss of the business.
Before – In EBITDA, the word before stands for excluding. Before can also mean adding in the formula. Since the items, i.e. interest, tax, depreciation and amortization are already subtracted from the net profit, these are simply added back to the net profits to exclude them. This means that the EBITDA of business will be higher than its net profits.
Interest – Interest refers to any interest paid on the financing of the business. The interest charge on financing activities is reported in the Statement of Profit or Loss of a business under the “Financial Expenses” heading. Interest expenses are excluded because they are related to the financing component of a business. Generally, interest is not considered an important indicator of the performance of a business. Therefore, it is not included in EBITDA. All other variations of EBITDA also do not consider interests. These include EBIAT, EBID, EBIDA, EBITDAR, etc.
Taxes – Taxes include all taxes imposed on a business. The taxes of business are dictated by the local jurisdiction of the business. Therefore, a business may have different tax expenses for the same performance in different jurisdictions. Hence, taxes are not an indicator of the performance of a business. Consequently, taxes are also excluded from EBITDA.
Depreciation – Different businesses may have different types of assets with different values. Depreciation may be considered an indicator of performance for some businesses. For most other businesses it does not matter. This mostly because assets will accumulate depreciation regardless of whether the operations of the business continue or not. Therefore, depreciation is also not considered in EBITDA.
Amortization – Amortization is related to the amount of debt a business has accumulated. This means that amortization, similar to interest expense, cannot be dictated by the operational efficiency of the business. Amortization also varies from one business to another according to the value of their debts, therefore, for better comparison, these are also ignored.
Why EBITDA is Important?
As mentioned, EBITDA is very important for businesses and their investors. First of all, investors use the EBITDA of a business to determine the operating efficiency of the business. They can also use it to check the long-term potential of the business. For example, investors can use it to determine whether businesses with declining profits or losses have made a loss due to operating deficiencies or due to finance costs.
It also makes a comparison of different businesses easier. This is because different businesses will have different accounting and capital structures. By excluding any items that don’t depend on the operations of the businesses from their earnings, the comparison becomes more like with like. This makes it a better tool for comparison of the earnings of a business rather than comparing the net profits of two businesses.
Similarly, the EBITDA of a business can help the management and the owners of a business determine whether the business is operating efficiently. This can help them realize if any deficiencies exist with the processes of the business and help make decisions regarding them on time. This means that it can also help in the decision-making process of a business. Similarly, business owners can use it as a measure of the profitability of the business as compared to other businesses.
Investors also use it as a proxy for cash flow. This is mainly because the non-cash items of a profit or loss account are excluded from the calculations. This means that it can represent the cash flows generated from the current operations of the business. It can also help investors easily and quickly estimate the value of a business. Business owners can also use it to determine the value of their business before selling it.
EBITDA Formula
So how to calculate EBITDA?
It can be calculated by using the formula below. This formula is very straightforward.
EBITDA = Net profit (Earnings) + Interest + Taxes + Depreciation + Amortization
All the information necessary to calculate the EBITDA of business is readily available in the Statement of Profit or Loss of business.
We can also be calculated it using another formula. This formula might be simpler for use within the business rather than by third-parties. The formula can be written as:
EBITDA = Total Revenues – Total Expenses (excluding interest, taxes, depreciation and amortization)
Similarly, the calculation of EBITDA can also be done using the following formula:
EBITDA = Operating Income + Depreciation + Amortization
EBITDA Margin
One of the important ratios which depend on the calculation of EBITDA is the EBITDA margin. It is similar to net profit or gross profit margin but calculated using EBITDA. The EBITDA margin of a business is an indicator of the operational profitability of the business. It can be used after the calculation of EBITDA to give investors and business owners a better understanding of the business’ profitability and cash flows. This margin is presented in the form of a percentage.
The EBITDA margin has the same advantages over the net profit margin as EBITDA has over net profit. EBITDA margin gives a bird-eye view of the performance and operations of a business. Usually, a high EBITDA margin indicates a good operating efficiency.
The formula to calculate the EBITDA Margin of a business is as follows:
EBITDA Margin = EBITDA / Net Sales Revenue x 100
Example and Analysis
A company, ABC Co. had Net Sales of $200 million. Its net profit for the period was $30 million and its operating profit for the period was $33.5 million. The total depreciation expense of the company was $2.5 million. The total amortization expense that ABC Co. charged in its financial statements was $1 million. The company also incurred interest expenses of $1.5 million during the period. Finally, the company paid a total of $2 million in taxes to reach the net profit.
The EBITDA of the company can be calculated using the following formula:
EBITDA = Net profit + Interest + Taxes + Depreciation + Amortization
EBITDA = $30 million + $1.5 million + $2 million + $2.5 million + $1 million
Hence, EBITDA = $37 million
Similarly, the EBITDA of the company can also be calculated using the following formula:
EBITDA = Operating Income + Depreciation + Amortization
EBITDA = $33.5 million + $2.5 million + $1 million
Hence, EBITDA = $37 million
ABC Co. can also calculate its EBITDA Margin with the given data. The EBITDA Margin of ABC Co. can be calculated using the following formula:
EBITDA Margin = EBITDA / Net Sales
EBITDA Margin = $37 million / $200 million x 100
Hence, EBITDA Margin = 18.5%
Another company, XYZ Co., within the same industry as ABC Co., had Net Sales of $100 million. Its net profit for the period was $12 million and its operating profit for the period was $15.5 million. The total depreciation expense of the company was $3 million. The total amortization expense that ABC Co. charged in its financial statements was $1.5 million. The company also incurred interest expenses of $2 million during the period. Finally, the company paid a total of $1.5 million in taxes to reach the net profit.
To calculate the EBITDA of XYZ Co., the same formulas can be used. First of all, the calculation of EBITDA can be done using the following formula:
EBITDA = Net profit + Interest + Taxes + Depreciation + Amortization
EBITDA = $12 million + $2 million + $1.5 million + $3 million + $1.5 million
Therefore, EBITDA = $20 million
Similarly, the EBITDA calculation can be done using the following formula:
EBITDA = Operating Income + Depreciation + Amortization
EBITDA = $15.5 million + $3 million + $1.5 million
Thus, EBITDA = $20 million
Finally, the EBITDA Margin of XYZ Co. can be calculated using the following formula:
EBITDA Margin = EBITDA / Net Sales
EBITDA Margin = $20 million / $100 million x 100
Thus, EBITDA Margin = 20%
It can be seen that even though XYZ Co. generated lower sales and lower net profits as compared to ABC Co., its EBITDA margin is 1.5% higher than ABC Co. This means that XYZ Co. has operated at a more efficient level as compared to ABC Co. Similarly, ABC Co. incurred only $7 million in interest, tax, depreciation and amortization expenses while XYZ Co. incurred $8 million. This means that XYZ Co.’s net profit was affected more by financing and accounting structure related expenses.
For even further analysis, the EBITDA and EBITDA margin of both companies can be compared with the industry as a whole.
Limitation
While EBITDA can be very useful for both companies and owners, it has some disadvantages as well. The first disadvantage of it is that is still based on the Net profits of the business. Businesses can easily manipulate information to get a favourable EBITDA. Similarly, some of the other components necessary in the calculation of EBITDA such as depreciation can also be manipulated.
Similarly, as discussed above, investors use it as a proxy for the cash flows of a business. However, it does not take into account the working capital changes of business. Similarly, due to its ignorance of working capital changes, it cannot be used as an indicator of the profitability of a business. In simpler terms, the EBITDA of a business cannot be used as an indicator of the liquidity of a business.
While it is used by some investors and owners to determine the value of a business, it should not be used on its own for this purpose. Investors and owners should consider other more important indicators of a company’s value rather than rely on it alone. This is because it does not give full information regarding the value of a business and is also prone to manipulation.
Conclusion
There are many ratios and statistics that investors can use to evaluate businesses for investment. One of these is the EBITDA of a business. It is the abbreviation of Earnings Before Interest Taxes Depreciation and Amortization. The EBITDA of a business is an indicator of the operational efficiency and performance of a business. It can be used by investors and businesses for different purposes. These may include using EBITDA as a comparison tool between different businesses, as an indicator of the operational performance of a business, an indicator of cash flows, etc. Although it is widely used, it may have some limitations.
