What Does EBITDA Mean?
Written by Team 365 finance
EBITDA is an alternative to net profit and is a common way to measure profitability in business. However, before talking to investors or lenders, you must know how to use it. Read on to find out what EBITDA stands for, how to calculate it, and more below.
What Does EBITDA Stand For?
EBITDA (pronounced “ee-bit-da”) is an acronym made up of five key sources of profitability and expenditure in business. Combined, they create a formula that can demonstrate your business’s financial health at a glance using a single figure. The acronym is spelled out in full below:
Earnings refers to your net income. This is the money leftover from your revenue after you’ve accounted for legitimate business costs, like your overheads
Don’t include any tax or interest deductions when calculating this figure since you’ll risk undercounting your business’s true EBITDA figure. As you’ll see, you add these expenses on rather than subtract them, so it’s important to get it right.
Note, the ‘B’ in EBITDA stands for ‘before’. This refers to all the items listed below that you’ll also use later in the formula.
Interest is the money you pay on any money that you’ve borrowed.
It’s usually expressed as an annual percentage rate (APR), which makes it easier to calculate if you pay in regular instalments. However, if you have multiple loans, you’ll need to calculate each interest figure separately before you use it in the EBITDA formula.
Taxes are all the money you pay the HMRC as part of your annual tax return.
At a minimum, you will either pay income or corporation tax, as well as other types of tax, depending on your business.
Depreciation refers to the decrease in the value of your business’s physical assets. For example, your car or van will lose value the more you drive it.
Depreciation can help you spread the cost of assets across their useful lifetime instead of expensing them in a single year. However, depreciation can be difficult to calculate, especially since different types of assets lose value at different rates.
It’s best to speak with a qualified accountant and use industry standards in your calculations in case HMRC ever queries them.
Amortisation describes how businesses spread the cost of non-physical assets (like patents or copyright) over time, or the money you pay on loans.
You may have loans out on business assets, which means you’ll need to account for the depreciation of their value as well as the amortisation of the loan associated with them.
What is EBITDA Used for and Why is it Important?
EBITDA is designed as a measure of your business’s core profitability without things like taxes or loan interest in the way (since they can be minimised with the right accounting advice). The EBITDA formula is particularly useful to demonstrate your profitability if you have expensive debts or assets.
EBITDA, therefore, allows investors and lenders to assess businesses more easily, even if they have different business models, tax environments and capital costs.
What’s an Example of EBITDA Being Used?
EBITDA is used a lot in lending applications. For instance, a business owner can use their EBITDA figure to demonstrate their business is reasonably profitable with their current tools and assets.
However, as part of their lending application, they can show that a loan for a new production machine would double their capacity without destabilising their balance sheet with the new debt.
A typical breakdown of their EBITDA, from an initial revenue of half a million pounds, would look something like:
- Net Income: £105,000
- Interest: £25,000
- Taxes: £20,000
- Depreciation: £25,000
- Amortisation: £25,000
Giving a final figure of £200,000.
What Are the Advantages and Disadvantages of EBITDA for Businesses?
EBITDA figures aren’t perfect. That’s why it’s important to know the advantages and disadvantages of the formula before you start using it. Some of the key points about EBITDA are summarised below.
- EBITDA is a highly popular and widely understood formula for profitability in business. Using it means you can quickly and effectively communicate your business’s long-term potential.
- The formula doesn’t factor in your capital structure, meaning you can demonstrate your profitability regardless of how you use your debt, equity or cash.
- The EBITDA formula isn’t recognised under generally accepted accounting principles (GAAP), so even though it’s widely used, it shouldn’t be the only figure you use.
- EBITDA figures only ever offer a snapshot of your business, and the formula can mask poor financial management. As a result, some investors and lenders can be wary when EBITDA is used too often.
Remember to always be transparent in your calculations and have other data available to evidence your profitability in case you need it.
How to Calculate EBITDA in Your Business
EBITDA calculations are relatively straightforward. Use the EBITDA formula below with your business’s own data to generate a single profitability figure:
EBITDA = Earnings/Net income + Taxes + Interest + Depreciation + Amortisation
What is the EBITDA Margin?
EBITDA margin is your operating profit relative to your revenue. Like your net profit, it’s expressed as a percentage, using the following EBITDA margin formula:
EBITDA margin = EBITDA / total revenue
After you’ve used the formula above, simply divide by your total annual revenue.
Is a higher or lower EBITDA margin better?
Generally, a higher EBITDA figure or margin is better (since it means your business is more profitable).
However, every industry has typical margins. For example, hospitality businesses may see less than 5% profit, whereas an IT consultancy firm may generate double digits. Make sure to use similar business examples to better understand your performance and manage your expectations.
How Can I Improve the EBITDA Figure for my Business?
Because the way the formula works (adding your expenditure back to your initial profit), there are various ways you can improve your EBITDA figure. However, the most reliable way is like any other advice in business: increase your revenue and minimise your expenses.
What Are Other Terms Related to EBITDA?
EBITDA is sometimes used alongside other financial metrics, each of which describes different aspects of your business’s financial performance. Some of the main terms are:
1. What is EV / EBITDA
One example is the EV/EBITDA ratio, also known as the enterprise multiple, which divides your enterprise value (or total value) by your EBITDA figure. Like earnings, this ratio uses your EBITDA figure to help shape your company’s valuation and lets investors know how much your business is worth.
2. What is a good EV to EBITDA ratio?
While it might be tempting to think that a higher EV to EBITDA ratio is better, the best figure is an accurate one. Investors and lenders may ask questions about your valuation, so it’s important you’re able to justify it with reasonable assumptions and accurate calculations.
3. What is the EBITDA multiple?
The EBITDA multiple is another term for the enterprise multiple, or EV/EBITDA ratio, discussed above. Lenders might use slightly different terminology when discussing your business, so it helps to know the alternative names for common financial terms.
4. What is the debt to EBITDA ratio?
Your debt to EBITDA ratio is the amount of income you have available to pay any debts your business has. Ideally, this number should be as low as possible but can be higher depending on your business model.
5. EBITDA vs EBT and EBIT?
EBITDA, EBT, and EBIT are all related – each refers to your ‘earnings before’ whichever expenses are then specified in the acronym.
6. EBITDA vs Operating Cash Flow?
Profitability under EBITDA doesn’t factor in interest or taxes (since they’re added back to your total); they are under operating cash flow because they’re cash expenses.
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