Table of Contents Show
- What exactly does EBITDA stand for?
- Deeper insights
- Leveraged Buyouts and EBITDA
- What exactly is LTM EBITDA?
- What is the difference between EBIT and EBITDA?
- Formula and How to calculate EBITDA
- What is the importance of EBITDA?
- The Advantages and Disadvantages of EBITDA in Business Valuation
- What Makes a Good EBITDA?
- What is EBITDA Margin?
- What is excluded in adjusted EBITDA?
- What is EBITDA multiple?
- Enterprise Value (EV) / EBITDA Multiple Calculation
- What is adjusted EBITDA? How does it work?
- EBITDA VS NET INCOME
- EBITDA vs operating income
- How to increase EBITDA (Earnings Before Interest and Taxes)
- Recasting EBITDA Value
- Frequently Asked Questions
The financial metric EBITDA is an abbreviation for Earnings before interest, taxes, depreciation, and amortization. It is a measure of a company’s overall financial performance and is sometimes used instead of net income. In contrast, EBITDA can be misleading because it excludes the cost of capital investments such as property, plant, and equipment.
This metric also excludes debt-related expenses by deducting interest and taxes from earnings. Nonetheless, it is a more accurate measure of corporate performance because it can show earnings before accounting and financial deductions.
In a nutshell, EBITDA is a measure of business profitability. While companies are not required by law to disclose their EBITDA, according to generally accepted accounting principles (GAAP) in the United States, it can be calculated and reported using the data found in the financial statements of a company.
Earnings, taxes, and interest are typically found on the income statement, whereas depreciation and amortization are usually found in the notes to operating profit or on the cash flow statement. Thus, the most common method for calculating EBITDA is to begin with operating profit, also known as Earnings Before Interest and Tax (EBIT), and then add depreciation and amortization.
What exactly does EBITDA stand for?
The acronym EBITDA means the following:
- E = Earnings
- B = Before
- I = Interest
- T = Taxes
- D = Depreciation
- A = Amortization
The key terms in Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) are defined in greater detail below:
- Interest – the costs incurred by a business due to interest-rates, such as loans provided by a bank or other thirdparty.
- Taxes are the costs businesses incurs due to tax rates imposed by their city, state, and country.
- Depreciation is a non-cash expense that refers to the gradual decrease in a company’s assets value.
- Amortization is a non-cash expense that denotes the cost of intangible (off-balance-sheet) assets over time.
EBITDA is essentially net income (or earnings) that includes interest, taxes, depreciation, and amortization. EBITDA is a metric that finance experts uses to assess and compare profitability across companies and industries because it excludes the effects of financing and capital expenditures. In addition, EBITDA is frequently used in valuation ratio calculations and can be used to compare enterprise value and revenue.
EBITDA is frequently used in valuation ratio calculations and can be used to compare enterprise value and revenue.
Net income increases by adding back interest expenses and (to a lesser extent) interest income, which balances out the cost of debt and reduces the impact interest payments have on the tax bill. EBITDA does not always increase if a company has a net loss because of the addition of income taxes. When a company’s net income isn’t particularly impressive (or even positive), it focuses on its EBITDA performance. It’s not always a sign of malicious market manipulation, but it can be used to divert investors’ attention away from a lack of real profit.
Businesses uses depreciation and amortization accounts to expense the cost of the property, plants, equipment, and capital investments. Amortization is frequently used to deduct the costs of software development or other intellectual property. This is one of the reasons that early-stage technology and research companies reference EBITDA when communicating with investors and analysts.
Management teams will argue that EBITDA offers a clear picture of profit growth trends when capital expense accounts are excluded. However, while using EBITDA as a growth metric is not necessarily deceptive but it can sometimes overshadow a company’s actual financial performance and risks.
- EBITDA is a popular metric for measuring corporate profitability.
- It can be used to compare companies to one another as well as to industry averages.
- EBITDA is a good way to measure core profit trends because it removes some extraneous factors and allows for a more accurate comparison of companies.
- Companies can use EBITDA as a quick way to estimate the cash flow available to pay off long-term asset debt.
Leveraged Buyouts and EBITDA
EBITDA rose to prominence in the mid-1980s as leveraged buyout investors audited distressed companies in need of financial restructuring. They used EBITDA to quickly determine whether these companies could repay the interest on these financed transactions.
Leveraged buyout bankers promoted EBITDA as a metric for evaluating a company’s ability to service its debt in the short-term. These bankers argued that examining a company’s EBITDA-to-interest coverage ratio would provide investors with an indication of whether or not the company would be able to meet the higher interest payments it would incur after restructuring. For example, bankers might argue that a company with $5 million in EBITDA and $2.5 million in interest charges has interest coverage of two, which is more than enough to pay off debt.
In the 1980s, EBITDA was a popular metric for assessing a company’s ability to service the debt used in a leveraged buyout (LBO). It is appropriate to use a limited profit measure before a company becomes fully leveraged in an LBO. EBITDA became more popular during the “dot com” bubble when companies had very expensive assets and debt loads that obscured what analysts and managers perceived to be legitimate growth numbers.
What exactly is LTM EBITDA?
LTM (Last Twelve Months) EBITDA, also known as Trailing Twelve Months (TTM), is a valuation metric that shows your EBITDA (earnings before interest, taxes, depreciation, and amortization) over the previous 12 months.
What is the difference between EBIT and EBITDA?
The number of steps taken is the main difference between EBITDA and EBIT. EBIT (Earnings Before Interest and Tax) only shows earnings before the effects of interest and tax rates. EBITDA goes a step further by identifying and removing depreciation and amortization expenses.
As a result, it is not a case of EBITDA vs EBIT. However, both are useful when putting together a picture of a company’s worth, as they break down business expenses and their relative impact on its value.
Other EBITDA variations worth noting are as follows:
EBIAT means Earnings Before Interest After Taxes
EBID means Earnings Before Interest and Depreciation
EBIDA means Earnings Before Interest, Depreciation, and Amortization
EBITDAX means Earnings Before Interest, Tax, Depreciation, Amortization, and Exploration
EBITDAR means Earnings Before Interest, Tax, Depreciation, Amortization and Restructuring/Rent Costs
EBITDARM means Earnings Before Interest, Tax, Depreciation, Amortization, Rent, and Management Fees.
All calculations can be instrumental in determining the value of a business. This is why prospective buyers and investors frequently use them to compare companies. As a result, most seasoned M&A professionals utilize EBITDA as a critical element of their clients’ exit preparations, in addition to a variety of other tools and methods.
Formula and How to calculate EBITDA
EBITDA can simply be calculated using data from a company’s income statement and balance sheet. There are two EBITDA formulas: the first formula starts with operating income, while the second formula starts with net income.
- Using Operating Income
The first EBITDA formula is as follows:
Operating income is a company’s profit after deducting operating expenses or the costs associated with running the business daily. By excluding interest and taxes, operating income allows investors to separate earnings for the company’s operating performance. Thus, operating income, as the name implies, shows how much money a company makes from its operations.
The most common way of calculating operating income is by subtracting sales from operating-expenses such as wages and the cost of goods sold (COGS). However, operating income is already calculated before interest and taxes are deducted, so only D&A is required to calculate EBITDA.
- Using Net Income
The second EBITDA formula is:
Unlike the first formula, which starts with operating income and adds back taxes and interest expense to arrive at net income, the second formula starts with net income. It then adds back taxes and interest expenses to arrive at operating income. The net income, tax expense, and interest expense figures, like the operating income from the formula above, can be found on the income statement.
The two EBITDA calculations can produce different results because net income includes items not included in operating income, such as non-operating income and one-time expenses (e.g., restructuring charges).
A retail company earns $100 million in revenue while spending $40 million on production and $20 million on operating expenses. Depreciation and amortization expenses total $10 million, resulting in a $30 million operating profit. Interest expense is $5 million, which equals $25 million in earnings before taxes. With a 20% tax rate, the net income equals $20 million after deducting $5 million in taxes from pre-tax income. EBITDA equals $40 million when we add back depreciation, amortization, interest, and taxes to net income.
Investors commonly use EBITDA to compare companies with different capital structures or tax jurisdictions. Assuming that both companies are profitable on an EBITDA basis, a comparison like this could assist investors in identifying the company that is growing faster in terms of product sales.
Consider two companies that have different capital structures but operate in the same industry. Company A currently has an EBITDA of $20,000,000, while Company B has an EBITDA of $17,500,000. An analyst is comparing the two companies to see which one offers the best value.
Given the information presented, it seems reasonable to assume that Company A has a higher total value than Company B. However, once we factor in the operational expenses of depreciation and amortization, as well as interest expense and taxes, the relationship between the two companies becomes clearer.
In this example, the net income of both companies is the same, primarily because Company B has a smaller interest expense account. However, there are a few possible outcomes that can assist the analyst in determining the true worth of these two companies:
These outcomes are
- Is it possible for Company B to borrow more money while increasing its EBITDA and net income? Underutilization of the company’s borrowing capacity could be a source of potential growth and value.
- If both companies owe the same amount of money, Company A may have a lower credit rating and must pay a higher interest rate. This may indicate greater risk and a lower value when compared to Company B.
- Company B generates less EBITDA with more assets than Company A due to the amount of depreciation and amortization. This could point to an ineffective management team and a problem with the valuation of Company B.
What is the importance of EBITDA?
Here are the two reasons why understanding how to calculate EBITDA is critical for business owners:
- Getting a better understanding of your company’s worth.
- Demonstrating its worth to buyers and investors
As previously stated, EBITDA allows you to analyze and compare profitability across companies and industries by removing the effects of financing, government, and accounting decisions. This gives you a more raw, clear picture of your earnings.
Above all, EBITDA is now the standout formula and language used by professional buyers, private equity investors, and others when discussing business value. It is usually used as a proxy for cash flow, and using the EBITDA multiple can help provide an overall estimated valuation range for your company.
The Advantages and Disadvantages of EBITDA in Business Valuation
As a widely used business valuation metric, EBITDA provides significant benefits to owners, analysts, and acquirers by providing a fair representation of a company’s value. However, it is important to note that it is a manipulable metric, potentially leading to negative consequences in the future.
- It’s widely used- As previously stated, many groups, particularly buyers and investors, use EBITDA. In other words, it is a language they are very familiar with, which means they can use it effectively to compare business valuations.
- It removes unhelpful variables – by removing variables such as interest rates, tax rates, depreciation, and amortization that differ from one business to another, EBITDA provides a clear picture of a company’s operating performance.
- It’s simple to calculate – as long as your financials are correct, all EBITDA formulas are straightforward to determine. This also makes it simple for all parties involved in any negotiations to understand.
- It’s dependable – Because it allows investors to focus solely on a company’s baseline profitability, businesses regard EBITDA as a more reliable indicator of its financial health.
- Non GAAP Measure – EBITDA does not fall under the generally accepted accounting principles (GAAP) as a measure of financial performance. Since EBITDA is a “non-GAAP” measure, its calculation varies from company to company. It is common for companies to emphasize EBITDA than net income because it is more adaptable and can divert from other issues in the financial statements.
- Suspicions from Investors – Investors are usually wary of companies that suddenly start reporting EBITDA prominently after not doing so in the past. For example, this can happen when a company is in serious debt or is facing rising capital and development costs. In this case, EBITDA can be a source of distraction for investors and may be misleading.
- Tends to ignore Asset Costs – It’s a common misconception that EBITDA equals cash earnings. However, unlike free cash flow, EBITDA does not take into account the cost of assets. One of the most common criticisms at EBITDA is that it assumes profitability is solely a function of sales and-operations. Almost as if the assets and financing required to survive are gifts.
- Neglects Working Capital – EBITDA also excludes cash needed to fund working capital and the replacement of old equipment. For example, a company may profitably sell a-product, but how did it acquire the inventory required to fill its sales-channels? EBITDA does not account for the cost of developing current software-versions or upcoming products in the case of a software-company.
- Varying Starting Points – While deducting interest payments, taxes, depreciation, and amortization from earnings may appear simple; different companies use different earnings figures as their starting point for EBITDA. In other words, EBITDA is vulnerable to income statement accounting games. Even after considering the distortions caused by interest, taxes, depreciation, and amortization, the EBITDA earnings figure remains unreliable.
- It obscures the valuation of a company – EBITDA can make a company appear cheaper than it is. As a result, analysts produce lower multiples when looking at stock price multiples of EBITDA rather than bottom-line earnings.
Consider the case of Sprint Nextel, a wireless telecom operator from the past. The stock was trading at 7.3 times its expected EBITDA on April 1, 2006. That may appear to be a low multiple, but it does not imply that the company is a steal. Sprint Nextel traded at a much higher 20 times the forecast operating profit multiple. The company’s stock was trading at 48 times its estimated net income.
When determining a company’s value, investors must consider price multiples other than EBITDA.
What Makes a Good EBITDA?
EBITDA is a metric that measures a company’s financial performance and profitability, so a higher EBITDA is preferable to a lower EBITDA. The Financial performance of companies of different sizes, sectors, and industries varies significantly. So, comparing a company’s EBITDA to that of its peers (companies of similar size in the same industry and sector) is the best way to determine whether its EBITDA is “good.”
What is EBITDA Margin?
Here is the formula to calculate EBITDA margin
EBITDA margin indicates how much cash profit a company makes in a single year by calculating EBITDA percentage against total-revenue. If your company has a higher profit margin than another, professional buyers will likely see more growth potential in yours.
Assume Company A has determined that their EBITDA is $600,000 and their total revenue is $6,000,000. This results in a 10% EBITDA margin. This contrasts with Company B, which has a higher EBITDA of $750,000 but a total revenue of $9,000,000.
This means that, while Company B has a higher EBITDA, it has a lower margin than Company A. (8% against 10% ). As a result, a prospective buyer weighing the pros and cons of both businesses may prefer A over B.
Using the EBITDA margin, an investor, owner, or analyst can see how much operating cash the business generates relative to total revenue earned and use this as a benchmark to determine which is the most financially efficient.
What is excluded in adjusted EBITDA?
Here’s an outline of the standard balance-sheet features that aren’t considered when calculating adjusted EBITDA:
- Non-operating revenue
- Unrealized profits or losses
- Non-cash expenses
- One-time profits or losses
- Compensation based on shares
- Litigation costs
- Special donations
- Impairment of goodwill
- Asset write-downs
- Gains or losses in foreign exchange
What is EBITDA multiple?
To calculate the EBITDA multiple, you must first determine your Enterprise Value (EV). You can calculate the EV by adding the following numbers in your organization:
- Market capitalization
- Value of debt
- Minority interest
- Preferred shares
Then subtract your cash and cash equivalents (bank accounts, treasury bills, securities, treasury bills, etc.). And then apply the following formula:
Enterprise Value (EV) / EBITDA Multiple Calculation
The EV/EBITDA multiple ratios tell analysts, M&A professionals, and financial advisors whether your company is overvalued or undervalued. A high ratio indicates that your company is overvalued, whereas a low ratio indicates that it is undervalued. In addition, the EBITDA multiple has the advantage of accounting for company debt, which other multiples, such as the Price to Earnings ratio, do not.
When preparing to market and communicate with buyers as part of your exit strategy, speak to them on their terms and present financials they will understand. Therefore, If you want to give buyers an idea of your company’s potential, you must use an EBITDA formula and present the results in the detailed documentation.
What is adjusted EBITDA? How does it work?
There are subtle but important differences between EBITDA and adjusted EBITDA. Adjusted EBITDA, in essence, normalizes this value based on a company’s income and expenses. These can differ significantly between companies, making it difficult for analysts and buyers to determine whether one is more appealing.
By standardizing income and cash flows and eliminating any anomalies (redundant assets, bonuses to owners, rent paid above market value, etc.), people can compare multiple businesses simultaneously, regardless of differences in industry, location, and other factors.
Calculating adjusted EBITDA is as simple as using one of the standard EBITDA formulas above. But go a step further by removing the cost of various one-time, irregular, and non-recurring expenses that have no bearing on the day-to-day operations of your company.
EBITDA VS NET INCOME
While EBITDA shows a company’s ability to generate consistent profits, net income shows the company’s total earnings. This difference implies that net income should be used to determine the value of earnings per share of a company rather than its overall earning potential; here is where EBITDA becomes useful.
EBITDA vs operating income
Operating income is a company’s profit after deducting depreciation and amortization. EBITDA takes it a step further by removing them entirely to provide a clear picture of its profitability.
Nonetheless, both are helpful calculations to use when valuing a business, as operating income effectively analyzes a company’s production efficiency and expense management.
How to increase EBITDA (Earnings Before Interest and Taxes)
When presenting your company’s financials and EBITDA for a business-exit, you should present data that spans the previous 3-5 years.
This volume of data demonstrates the evolution of your company over time, reassuring buyers that your growth potential is consistent and that you haven’t had one exceptional year.
Due to the extent of these projections, we strongly advise companies to work with financial experts to present realistic, dependable, and defendable values. The more accurate these are, the lower the risk prospective buyers and investors will associate with your company.
Once you’ve determined your company’s EBITDA, you’ll most likely want to boost its value before putting it on the market. Fortunately, this is achievable by recasting your financials.
Recasting EBITDA Value
Recasting is the act of amending and re-releasing previously released earnings statements with specific intent. In practice, an expert will scrutinize your financials and reinsert any one-time earnings or expenses.
This reexamination gives potential buyers a more accurate and promising picture of your company’s worth and potential. However, do not mistake it for manipulating your statements; due diligence will reveal any inconsistency, so this is not an opportunity to conceal the facts.
You can improve your company’s EBITDA and present a more accurate picture of its value by recasting numerous financial aspects.
These are some examples:
- Revenue/expenses from unnecessary assets: For example, if you rent a country house for a company retreat every year. This is an expense that a buyer may not pick up on.
- Owner salaries/bonuses: This will certainly be higher than those of other employees, but they will not be costs that a new owner must bear.
- One-time fees: If you paid for a lawsuit or a one-time marketing campaign, these are not expenses that a buyer would have to bear.
- Non-arms-length revenue/expenses – these are transactions in which your company pays more or less than market rates. For example, rent when one of the partners owns the building personally.
- Repairs/maintenance: Many private business owners will classify capital expenses under repairs to reduce taxes, but this hurts the company’s valuation in the long run by lowering its historical EBITDA.
These five areas are a few possible ways to normalize EBITDA, maximize it, and ensure it reflects your business valuation.
Frequently Asked Questions
The Debt-to-EBITDA ratio can be calculated by dividing the liabilities of a company by the value of its EBITDA. Thus, it assesses a company’s ability to repay its debts adequately. The lower the ratio, the more likely a company will be able to pay its obligations on time. In contrast, a higher value indicates that it may be difficult to clear its debts, acting as a warning sign for buyers.
Analysts and buyers use the EBITDA to sales ratio to compare a company’s revenue to its earnings in order to determine its profitability. This is calculated by dividing a company’s EBITDA by its sales. Sales-to-EBITDA can be used to compare similar-sized businesses when the underlying variables of their cost structures are unknown.
The EBITDA to fixed charges ratio, like the Debt to EBITDA ratio, measures a company’s ability to pay off fixed charges and related debts over a four-quarter trailing period.
The net profit margin is one of the most important indicators of a company’s financial health, and it is calculated using the formula:
Net Profit Margin = (Revenue – Cost of Goods Sold – Operating Expenses Expenses – Other Expenses – Interest – Taxes) / Revenue x 100.
Net Profit Margin indicates how much profit is generated per dollar of sales. However, EBITDA accounts for all production and day-to-day expenses while also adding back depreciation and amortization costs.
Cash Flow and EBITDA are two ways to determine a company’s worth and profitability. While EBITDA shows a company’s earning potential after removing necessary expenses such as interest, tax, depreciation, and amortization, free cash flow is unencumbered. Instead, it adjusts a company’s earnings by factoring in depreciation and amortization before reducing working capital changes and expenditures.
EBITDA does not fall under a Generally Accepted Accounting Principle (GAAP) to measure financial performance. In addition, since EBITDA is not standardized, its calculation varies from company to company.