EBITDA measures a business’s profitability and ability to pay a company’s debt. As such, it is important for corporate buyouts, business valuations and restructurings. EBITDA can be derived from a company’s financial statements but is not recognized under generally accepted accounting principles (i.e., it is non-GAAP), nor recognized under International Financial Reporting Standards for measuring management performance.
What Is EBITDA?
EBITDA is used by management, investors and analysts to represent a company’s cash profits stemming from operations. It is an acronym for earnings before interest, taxes, depreciation and amortization.
Depreciation and amortization are non-cash operating expenses. Depreciation is an accounting method that recognizes the loss of value of tangible assets such as machinery and vehicles over their useful life. Amortization is similar, except it pertains to a company’s assets that are intangible, such as patents and other intellectual property.
Companies use these two metrics to expense and tax-deduct the cost of assets over multiple years instead of all at once. In this way, an asset’s expense is more closely tied to its revenues. There are various ways to calculate depreciation and amortization, and often the values used on tax returns differ from those in a company’s financial statements.
How to Calculate EBITDA
You calculate EBITDA by adding back certain cash and non-cash expenses to net income. The add-back provides investors with a measure of corporate profitability isolated from tax strategy, financing decisions and the methods chosen to depreciate and amortize assets.
According to the Corporate Finance Institute, the two equivalent ways to express the EBITDA calculation are:
EBITDA = Net Income + Income Taxes + Interest Expense + Depreciation & Amortization
EBITDA = Operating Income + Depreciation & Amortization
Operating income (also called earnings before income and taxes, or EBIT) represents the revenues earned by a company’s operations. It excludes other revenues, such as the sale of assets or the proceeds from a court judgment. Net income is operating income after subtracting taxes and net interest payments (i.e., interest expense - interest income, both from operations). A company’s operating and net incomes appear in its income statement.
Depreciation and amortization are expenses already subtracted from operating income. By adding them back to operating income, you obtain EBITDA, a measure that excludes expenses that don’t affect operating cash flow. Depreciation and amortization figures are available in a company’s cash flow statement or the notes to operating profit.
Example of EBITDA Calculation
Suppose a company with a 20 percent tax rate has annual net sales of $50 million on goods costing $20 million to produce. It spends $10 million on overhead, such as accounting and marketing, and recognizes $5 million in depreciation and amortization expenses. Therefore, the operating income is ($50 million - $20 million - $10 million - $5 million), or $15 million.
The company has an interest expense of $2.5 million, leaving earnings before taxes of ($15 million - $2.5 million) or $12.5 million. Plus, the tax bill is equal to the tax rate (20 percent) applied to earnings before taxes ($12.5 million), reduced by the deduction on $2.5 million of interest:
Income Tax = (0.20 x 12.5 million ) - (0.20 x $2.5 million) = $2 million
Net income is the earnings before taxes ($12.5 million) minus taxes ($2 million), or $10.5 million.
In this example, EBITDA is $20 million.
Depreciation & Amortization
= $20 million
EBITDA vs. Other Income Metrics
EBITDA can be compared to other income metrics that measure operating performance:
- EBITDA vs. Revenue: Revenue is net sales, that is, sales - allowances, refunds and discounts. It is a top-line figure before the cost of goods sold is subtracted. Revenue measures sales activity, whereas EBITDA measures profitability.
- EBITDA vs. Gross Profit: Gross profit measures a company’s profit after deducting direct costs, reflecting operational efficiency. EBITDA adds back the non-cash costs (i.e., depreciation and amortization). Both metrics exclude interest and taxes.
- EBITDA vs. Net Income: Net income (or net profit) measures a company’s bottom-line financial performance after subtracting all costs. It is used to calculate earnings per share. EBITDA adds back four cost components to net income that reflect the impact of managerial decisions. It indicates the company’s total earning potential without regard to specific management policies.
- EBITDA vs. Adjusted EBITDA: Analysts often adjust EBITDA to remove the impact of one-time, irregular and non-recurring items. Adjusted EBITDA allows a more meaningful comparison of companies by eliminating abnormalities.
What Is a Good EBITDA?
What constitutes a good EBITDA varies by industry. Analysts use EBITDA margin to compare different companies:
EBITDA margin = EBITDA / total revenue
The EBITDA margin of the S&P 500 has ranged between 11 percent and 14 percent in recent years. An EBITDA margin above 10 percent is considered good. From an investor’s viewpoint, a company’s financial riskiness falls as the EBITDA margin rises.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.