EBITDA: What does it mean?
EBITDA is crucial for assessing creditworthiness or evaluating a company's cash flow for potential investors. However, it can also obscure true valuation, so careful analysis is necessary.
EBITDA was first invented in the 1970s by businessman John C. Malone, who owns Liberty Media. In the 1980s, EBITDA was a popular way for investors involved in leveraged buyouts to get a picture of a company’s core operating profit. This allowed them to assess whether a firm could service the debt involved in the acquisition.
EBITDA equals a company’s net income plus interest, tax, depreciation, and amortization expenses. Here’s a breakdown of what each of those means:
This is a company’s net profit, or total revenue from sales, minus reasonable business costs.
This is the amount of interest charged on any debt. This rate can vary depending on short- and long-term interest rates set by the government and central banks.
These are the taxes that a business is required to pay. Since tax rates can vary, measuring earnings before tax allows you to compare a company’s performance with a competitor or with earnings from a different operating period.
Depreciation represents the fall in the value of physical assets such as computer equipment or company vehicles. Depreciation is calculated by subtracting the asset’s resale value from its original cost.
Amortization is a technique that reduces the value of non-physical assets over time. These assets might include trademarks, copyrights, or patents. They usually don’t have any resale value.
Why is EBITDA important?
EBITDA is important because it gives lenders a picture of a company’s core operating profit before deducting variable expenses.
It’s also useful for prospective purchasers because debt is not transferred to a buyer on purchase. EBITDA gives a clear insight into a company’s performance without the cost of any debt.
EBITDA should be treated with caution, however. By excluding certain costs, it can skew the picture of a company’s true value. Using EBITDA alone to assess a company’s value can lead to ill-informed investments.
How do you calculate EBITDA?
There are two ways of calculating EBITDA:
You can add interest, tax, depreciation, and amortization expenses to a company’s net profit.
You can add depreciation and amortization expenses to EBIT (earnings before interest, taxes, or operating profit).
What is a good EBITDA margin?
Generally speaking, an EBITDA margin of ten percent or more is good – but this figure varies depending on the industry.
A high EBITDA margin usually shows a company is in good financial health and gives lenders and investors more confidence.
If a company’s EBITDA margin is low, it suggests its operating costs are too high and may indicate problems with cash flow. If that’s the case, it means the company should take a look at expenses and overheads to see where you can save money.
Pros and cons of EBITDA
EBITDA can give a useful overview of a company’s performance, but it ignores certain important factors if you’re assessing the value of a potential investment. Here are some of the pros and cons of using EBITDA as a tool for measuring the value of a business:
It gives a simple overview of business growth.
It shows how well operations generate cash and the value of that cash.
It’s useful for potential company purchasers because debt is not transferred to the buyer upon purchase. Prospective buyers tend to be most interested in cash flow and customers.
It ignores the cost of debt, so it can be used to conceal poor financial decisions.
It conceals financial burdens such as high-interest loans.
It doesn’t account for aging equipment that might be costly to replace.
It may not allow a business to get a loan – lenders often like to look at a company’s financial performance in more detail.
What is the difference between EBITDA, EBT, and EBIT?
As well as EBITDA, companies and investors use EBT and EBIT metrics to measure performance and profitability. But what do these mean?
EBT stands for earnings before tax and is sometimes called pre-tax income. It’s a calculation of a company’s earnings before taxes are deducted. This can help you more accurately compare a company’s performance against a competitor because the tax a company pays can vary from state to state.
EBIT stands for earnings before interest and tax. This metric shows a company’s earnings before these variable expenses are deducted and gives a picture of its profitability regardless of how it is structured and where it operates.
EBITDA and what it means for you
EBITDA is a useful measurement of a company’s core operating performance and can be used to identify any issues with cash flow. If you run a company with an EBITDA margin of more than ten percent, you’re likely to be on safe ground, but if it’s lower, you might want to reduce overheads.
On the other hand, if you’re an investor looking to buy equity in a particular company, EBITDA can be a useful way of getting a picture of its profitability.
However, it’s important to treat EBITDA with caution and to research a company’s wider financial performance before deciding to invest.
Whether you run your own company and want to improve your EBITDA margin or seek investment advice, our dedicated financial advisors can help. Just fill out our simple form to let us know more about your financial situation and your unique goals. We’ll then match you with a suitable financial advisor in your area.
Senior Content Writer
Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.