Earnings before interest, taxes, depreciation and amortization, or EBITDA, is often described as a profitability metric. That’s misleading: A business may report a net loss but still have positive EBITDA. It’s more accurate to call EBITDA a performance metric.
EBITDA is useful when comparing the financial performance of companies in different industries, with different capitalization structures, in different tax jurisdictions — or some or all of the above. That’s because EBITDA obscures the effects of taxes, capital expenditures and interest payments.
However, EBITDA can also obscure signs of financial stress, such as high debt and anemic cash flow. That’s why it should be just one factor in evaluating a company’s financial health.
What Is Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)?
Earnings before interest, taxes, depreciation and amortization (EBITDA) is a widely used measurement of the operating profitability of a business. While net income or loss — the profit after subtracting all costs, including taxes and non-operating expenses —is the only accurate measure of profitability, EBITDA has value in that it can give a clearer picture of a business’s ability to generate cash from core operations.
Finance teams calculate EBITDA by taking earnings and subtracting amounts paid for interest on loans, payments to all jurisdictions in which a company owes taxes and the depreciation and amortization deductions associated with capital assets.
- EBITDA removes the potentially distorting effects of taxes, interest and depreciation and amortization.
- Because of this leveling effect, EBITDA can help business leaders, lenders and investors compare companies against other firms around the world.
- Still, EBITDA can also mask potential problems, such as excessive debt, poor cash flow and high borrowing costs.
- EBITDA doesn’t indicate whether a company’s financial position is sustainable —that is, whether it can service existing debit and continue investing in the business.
- When evaluating a company for investment, EBITDA should always be used in conjunction with other financial metrics.
EBITDA measures a business’s profitability without the potentially distorting effect of taxes, interest on debt and deductions associated with capital expenditures. Specifically, the expenses that are excluded from EBITDA but included when calculating net income are:
- Interest paid on borrowing, such as bank loans and bonds.
- Taxes paid.
- Depreciation via the decline in value of tangible assets, such as real estate or manufacturing equipment.
- Amortization via the decline in value of intangible assets, such as patents or goodwill.
Removing these items from the calculation can enable potential purchasers, lenders and investors to accurately compare the profitability of companies that have very different capital structures and asset bases, or that operate in different tax jurisdictions.
However, EBITDA can give a misleading impression of a company’s resilience because interest and taxes are real business costs, and depreciated assets must eventually be replaced.
EBITDA does not conform to U.S. Generally Accepted Accounting Principles (GAAP), and not all companies report it. While EBITDA can be readily calculated from a public company’s financial statements, it may also be used by, and to evaluate, private firms.
EBITDA Formula & Calculations
There are two common ways of calculating EBITDA.
The first method starts with net income and adds back interest on borrowings, such as bank loans and bonds issued, as well as taxes paid and the noncash value of depreciation and amortization. The formula can be written as follows:
EBITDA = Net Income + Interest + Taxes + (Depreciation + Amortization)
All of these items can be found in a public company’s financial statements. Net income, interest and taxes are typically on the income statement. Depreciation and amortization may be listed on the income statement, but if not, they’re typically in the cash flow statement and/or the notes accompanying published accounts. Some companies combine depreciation and amortization and report them as a single item.
The second method starts with EBIT (or operating income, which is the same as EBIT if there are no non-operating expenses or income) and adds back depreciation of fixed assets and amortization of intangible assets. The formula can be written as follows:
EBITDA = EBIT + (Depreciation + Amortization)
Examples of EBITDA
Example 1. Suppose a company’s income statement looks like this:
|Cost of goods sold (COGS)||$ 800,000|
|Sales, general & administrative expenses||$ 120,000|
|Depreciation and amortization||$ 45,000|
|Operating income (EBIT)||$ 235,000|
|Interest expense||$ 70,000|
|Tax paid||$ 50,000|
|Net Income||$ 115,000|
Calculating EBITDA using the first method:
EBITDA = Net Income + Tax Paid + Interest Expense + Depreciation & Amortization
= $115,000 + $50,000 + $70,000 + $45,000
However, in this example, operating income is shown in the income statement. So, calculating EBITDA using the second method is even simpler than with the first method:
EBITDA = Operating income + Depreciation & Amortization
= $235,000 + $45,000
Example 2. A company’s income statement may look like this:
|Cost of sales (COGS)||$ 845,000|
|Operating expenses||$ 120,000|
|Interest expense||$ 70,000|
|Tax paid||$ 50,000|
|Net income||$ 115,000|
In this example, depreciation and amortization are not listed separately on the income statement. To obtain those items, we need to look at the cash flow statement. The first section in the cash flow statement shows us this:
|Cash from Operating Activities|
|Less: depreciation and amortization||$ 45,000|
|Less: changes in working capital||$ 5,000|
|Cash from Operations||$ 65,000|
To calculate EBITDA using the first method, we add back depreciation and amortization as noted on the cash flow statement to net income. We also add back interest expense and tax paid from the income statement. So the calculation looks like this:
EBITDA = $115,000 + 45,000 + 70,000 + 50,000 = $280,000
Why Use EBITDA?
In general, EBITDA is useful as one factor when comparing companies with different capital structures. For example, businesses that have taken on debt to acquire expensive fixed assets that leadership believes will lead to growth may have lower net income — due to interest payments — compared with companies that have less debt. EBITDA eliminates the effect of interest, so it can make it easier to compare the underlying profitability of each business. EBITDA therefore tends to be used as a key performance measure by companies in highly leveraged, capital-intensive sectors such as telecommunications. Using EBITDA enables them to report higher earnings than their net income would suggest, because it excludes interest on debt.
This is only part of the reason highly leveraged companies may prefer to report EBITDA, however.
Because EBITDA also excludes depreciation and amortization, companies that own a lot of aging equipment that will soon need to be replaced or office real estate that has fallen in value deemphasizes the diminished worth of these assets. Depreciation and amortization are non-cash expenses, meaning they don't impact working capital, so including them makes results look worse than they really are.
Likewise, an EBITDA calculation enables companies with excessive tax liability or that are based in high-tax locales to exclude the real cost of local, state and federal taxes. In this case, the company may favor earnings before interest, depreciation, and amortization (EBIDA).
Of course, a company may have a negative income tax liability if it experienced significant losses or reductions in sales, or benefited from generous tax breaks or credits, making EBIT a more attractive performance metric.
EBITDA weaknesses:As suggested by the fact that EBITDA is not accepted under GAAP, it is of very limited value in providing a complete picture of a company’s performance.
EBITDA is useful for investors looking to compare two or more public companies, because stakeholders can drill down into financial reports to see whether use of this metric is making business results look better than they actually are.
For example, consider these two companies with similar business lines but different capital structures. Both have net income of $150,000, but very different EBITDA:
|Company A||Company B|
|Interest expense||$ 50,000||$ 10,000|
|Taxation||$ 10,000||$ 15,000|
|Depreciation & amortizationral||$ 30,000||$ 5,000|
Company A’s higher interest expenses, depreciation and amortization might suggest that it has borrowed heavily to invest in assets. However, the higher interest costs could also mean that the company has a poorer credit rating and is therefore paying higher interest rates than company B. On the other hand, company B’s lower EBITDA, coupled with lower interest expenses, depreciation and amortization, might suggest that it is suffering from under-investment.
What Is a Good EBITDA?
Generally speaking, the higher EBITDA is, the more profitable the company. However, EBITDA tends to vary depending on industry, so leaders seeking to use this metric to evaluate their competitive positions should limit comparisons of their EBITDA to other companies in the same sector and geography — and even then, use caution.
EBITDA History: Leveraged Buyouts
EBITDA first became popular in the 1980s as a tool for investors specializing in leveraged buyouts, typically of distressed companies. In a leveraged buyout, the investor finances an acquisition with debt, then loads the debt onto the acquired company’s balance sheet. EBITDA helps tease out the underlying profitability of a business, so investors used it to assess whether a prospective acquisition would generate enough profit to service the new debt they planned to load on to its balance sheet.
Since then, EBITDA has become a widely used tool for evaluating company performance. Highly leveraged firms can use it to make a case to investors about the underlying profitability of their core businesses and convince lenders that they can service their debts. Fast-growing startups with large but short-term cash needs paired with potentially good profitability can use it to persuade investors to keep the cash flowing.
Using EBITDA in Modern Accounting
As mentioned, EBITDA does not comply with U.S. Generally Accepted Accounting Principles (GAAP), so is not required in corporate financial statements. Many companies do still report EBITDA, but it does not replace U.S. GAAP-compliant metrics in financial reports.
EBITDA in Financial Modeling
Business managers, investors and analysts build financial models to help them forecast the likely future performance of a company based on its historical performance. Financial models may be used to project, estimate or forecast EBITDA.
EBITDA is also the starting point for a number of other key performance metrics calculated in financial models, such as the debt-to-EBITDA ratio; EBITDA coverage, which indicates the company’s ability to service its debts; and EBITDA multiple, a measure of the value of the company.
How to Increase EBITDA
There are three primary ways to improve EBITDA: Increase sales revenue, reduce the cost of sales or cut operating costs — or use some combination of the three.
One way to increase sales revenue is by raising prices, provided that customers are loyal to your brand. Alternatively, you could cut the cost of sales, perhaps by switching to less expensive suppliers. Many businesses increase EBITDA by cutting operating costs — taking actions such as reducing administrative headcount, making business processes more efficient and selling unprofitable business lines.
Benefits and Drawbacks of EBITDA
EBITDA can give a clean picture of the profitability of a business without the distorting effects of taxes and the way that assets are financed and expensed. It is easily calculated and simple to understand. It can be applied to companies with very different capital structures, across multiple tax jurisdictions, thus helping business managers understand their competitors and investors to evaluate companies across entire industrial sectors.
EBITDA is also useful for companies that have been acquired via leveraged buyouts that left them with large debts. The need to service that debt means bottom-line profits tend to be lower than they would be with a less debt-laden capital structure. For these companies, EBITDA can bring the underlying profitability of business operations into focus.
Businesses looking for buyers may also prefer to emphasize EBITDA rather than net income. The capital structure of a company typically changes significantly when it is acquired by an investor or another company. Often, debt is converted to equity, written off or restructured. Acquirers may move a company’s headquarters to affect taxation and also revalue or dispose of company assets. So prospective buyers want to see the company’s underlying profitability without the effects of the existing capital structure and asset base.
EBITDA doesn’t give a complete picture of a company’s financial performance. In fact, it can be misleading because it ignores the effects of debt, taxes and factors associated with both tangible and intangible assets. Over-emphasizing EBITDA may distract attention from warning signs, such as high debt, high costs, inadequate cash flow and declining sales.
EBITDA is typically higher than bottom-line net income, so valuing based on EBITDA can give the impression that a company is more valuable than it would appear based on other metrics.
Limitations of EBITDA
Despite its popularity, EBITDA has significant limitations. These include:
- EBITDA is used by some investors to estimate cash flow. However, it does not reflect changes in working capital, which can have significant effects on cash flow. Because of this, it is possible for a company to have negative cash flow but positive EBITDA.
- EBITDA can conceal an unsustainable financial position. A company’s EBITDA may rise even though it has rapidly rising debt, high borrowing costs and negative cash flow.
- Excluding the effects of capital expenditures, such as depreciation and interest, may give the misleading impression that the company’s assets are cost-free.
- Some companies adjust EBITDA to exclude nonrecurring items, such as asset write-downs. The goal is generally to provide a better comparison with similar firms, but this practice can give a misleading impression of performance over time. For example, a company might write down or dispose of assets every year for several years, taking a succession of bottom-line losses. However, because its adjusted EBITDA does not include these losses, the metric could show an unrealistically positive picture of profitability.
Because of these limitations, EBITDA is best employed alongside other performance metrics, such as free cash flow, net debt and profit margins.
Q: What is the difference between EBITDA vs. EBT and EBIT?
EBT, EBIT and EBITDA are related performance metrics:
EBT = Earnings before taxes
EBIT = Earnings before interest and taxes
EBITDA = Earnings before interest, taxes, depreciation and amortization
Here’s how they compare:
EBT strips out the effect of taxation on a company’s bottom line. This enables business owners to assess profitability without the potentially distorting impact of taxes, which are outside their control and subject to change.
EBIT and EBITDA both remove the effect of capital structure from the company’s profitability. This tends to make companies with high debt and/or high interest costs look more profitable. EBITDA additionally removes depreciation and amortization costs related to capital expenditures. Thus, EBITDA tends to make companies with large asset bases look more profitable, especially if they are debt-financed.
On a scale from highest to lowest reported profitability, the sequence would typically be as follows:
Highest > EBITDA EBIT EBT Net Income < Lowest
Q: Is EBITDA the same as operating cash flow (OCF)?
People often treat EBITDA as equivalent to operating cash flow (OCF). But there is a crucial difference between the two measures. EBITDA measures the profitability of the business, whereas OCF measures cash flow from operations. OCF includes changes in working capital, whereas EBITDA does not. Under some circumstances, a company may have positive EBITDA but negative OCF.
An example of a company whose OCF was negative when its EBITDA was positive is the British outsourcing conglomerate Mitie. Its cash flow statement for the first half of 2017 looked like this:
|Opening net debt||(147.2)|
|Other non-cash items||0.9|
|Operating cash flow before movements in working capital||28.8|
|Working capital movement||(35.5)|
|Operating cash flow||(6.7)|
|Cash (used in)/generated by operations||(14.2)|
|Disposal of subsidiaries||(9.8)|
|Dividends and share buybacks||-|
|Interest, tax, capex||(4.1)|
|Other financing and investing||(1.0)|
|Non-cash movement on net debt||3.7|
|Closing net debt||(172.6)|
A large negative movement in working capital resulted in negative OCF despite the company’s positive EBITDA. The consequence of this was a large rise in net debt. This would increase the company’s interest expense in the following year. If the negative OCF continued, the company would eventually default, even with positive EBITDA.
Q: What is EBITDA margin and is it the same as the EBITDA to sales ratio?
EBITDA margin is a company’s profitability expressed as a percentage of its sales revenue. It is also known as the “EBITDA to sales ratio” and is calculated as:
EBITDA Margin = EBITDA/sales revenue
Calculating EBITDA Margin for a company with $1,200,000 in sales revenue and EBITDA of $280,000:
EBITDA Margin = (280,000/1,200,000) x 100 = 23.33%
Q: What is the EBITDA to sales ratio?
This is another name for EBITDA margin.
Q: Is EBITDA the same as gross profit?
EBITDA is not the same as gross profit. Gross profit is a simple measure of raw profit from revenue after deducting the cost of sales, whereas EBITDA also takes into account operating expenses. EBITDA is generally lower than gross profit.
Q: What is EBITDA coverage ratio?
The EBITDA-to-interest coverage ratio, or EBITDA coverage, is a measure of the company’s ability to meet its interest expenses from its profits. It is typically used by lenders to assess how much debt a company can handle. Sometimes, lenders set a condition for lending that requires the company to maintain EBITDA coverage above a specific value, such as 2.5.
There are two formulas for calculating EBITDA coverage. Many analysts prefer the first one, but the second is also used:
EBITDA Coverage Ratio = EBITDA + Lease Expense / Interest Expense + Lease Expense.
EBITDA Coverage = EBITDA/Total Interest Expense
So, if a company had EBITDA of $280,000 and interest expenses of $70,000 during the same period:
EBITDA Coverage = 280,000/70,000 = 4
Q: What is the net debt to EBITDA ratio?
The net debt to EBITDA ratio is a measure of the company’s indebtedness. It indicates how many years it would take the company to pay back all its debt if the amount of debt and EBITDA both remain unchanged. Lenders often set a maximum net debt to EBITDA ratio, such as 3.5, as a condition of lending.
Net debt is defined as the company’s total debt minus its cash and cash equivalents. So, the formula for calculating the net debt to EBITDA ratio is:
Net Debt to EBITDA Ratio = (total debt – (cash & cash equivalents))/EBITDA
If a company had EBITDA of $280,000, total debt of $1,500,000 and cash and cash equivalents of $500,000, its net debt to EBITDA ratio would be:
Net Debt to EBITDA Ratio = (1,500,000 – 500,000)/280,000
This company is rather highly leveraged and might find it difficult to borrow.
Q: What is the EBITDA multiple?
The EBITDA multiple is a measure of a company’s value. It’s a financial ratio that compares a company’s enterprise value (EV) to its profitability.
A company’s EV is its total market value, including all claims on assets. It is calculated as follows:
EV = Market Capitalization + Market Value of Debt – (Cash & Cash Equivalents)
EBITDA Multiple = EV/EBITDA
EV = $5,000,000 + $1,500,000 – $500,000) = $6,000,000
EBITDA Multiple = 6,000,000/280,000 = 21.43
Q: How do I compare EBITDA margin vs. profit margin?
U.S. GAAP recognizes three types of profit margin:
- Gross profit margin
- Net profit margin
- Operating profit margin
Because EBITDA is not a U.S. GAAP metric, EBITDA margin is not recognized in U.S. GAAP. However, many companies find it a useful measure of profitability in addition to the three U.S. GAAP measures.
Q: How does net income compare vs. EBITDA?
Net income includes taxes, interest expenses, depreciation and amortization, whereas EBITDA excludes all of those factors. In companies where these items are significant costs, EBITDA can be considerably higher than net income. For this reason, some companies prefer to use EBITDA as a key measure of profitability. However, the items EBITDA excludes are real expenses, and they can make a company vulnerable to shocks. For this reason, analysts often like to look at net income as well as EBITDA.
Q: How does operating income compare vs. EBITDA?
For some companies, operating income may be the same as EBITA. However, this is not always the case. The difference between operating income and EBITDA is that operating income includes asset depreciation and amortization, whereas EBITDA excludes it. For companies with large asset bases, therefore, EBITDA is typically higher than operating income.
Q: What is adjusted EBITDA?
Some companies use variations of EBITDA, known as adjusted EBITDA, that exclude non-recurring income or expenditure events and may include items that are typically present in the financial statements of peer companies within the same industry. The object is to create a measure that is more directly comparable with other companies in the industry.
However, because there’s no single definition of which costs should be included, adjusted EBITDA can be misused to give an inaccurate picture of profitability. Typical adjustments include:
- Non-operating income.
- Unrealized gains or losses.
- Non-cash expenses.
- Gains or losses on asset disposals.
- Litigation expenses and regulatory fines.
- Goodwill impairments.
- Asset write-downs.
- FX gains or losses.