What is EBITDA?

There is an array of acronyms and metrics that businesses use to assess their financial health and performance, one is earnings before interest, taxes, depreciation, and amortisation (EBITDA).

EBITDA is a crucial tool for businesses as it provides a clearer picture of their operational profitability, allowing them to make informed decisions and measure their financial performance more effectively.
We'll dive deeper into what EBITDA is, how it's calculated, and why it matters for businesses.

EBITDA meaning

EBITDA is a financial metric used to evaluate a company's operating performance without factoring in the impact of non-operational expenses, such as interest, taxes, depreciation, and amortisation. It offers a more direct view of a company's core profitability and operational efficiency by focusing solely on its ability to generate profits from its core business activities.

What does EBITDA stand for?

Earnings

This refers to a company's net income or profit after deducting all expenses, including cost of goods sold, operating expenses, and other items related to its primary business operations.

Before Interest

Interest expenses, such as those incurred on loans and credit facilities, are excluded from the EBITDA calculation. Removing interest expenses provides a clearer view of a company's operating profitability without the influence of its capital structure.

Taxes

Similarly, income taxes are omitted from EBITDA. This ensures that variations in tax rates or tax strategies do not distort the metric's comparability across different companies or industries.

Depreciation

Depreciation is a non-cash expense that accounts for the wear and tear of tangible assets like machinery and equipment. By excluding depreciation, EBITDA focuses on the cash generated by operations rather than accounting adjustments.

Amortisation

Amortisation is similar to depreciation, but relates to intangible assets like patents, trademarks, and copyrights. Omitting amortisation from EBITDA helps maintain consistency in measuring operational profitability.

EBITDA formula

You can calculate EBITDA using the following formula:

EBITDA = Net Income + Interest Expense + Tax Expense + Depreciation Expense + Amortisation Expense

The importance of EBITDA for businesses

EBITDA serves as an indicator of how well a company's core operations are performing, abstracting away the impact of financing decisions, tax regulations, and accounting methods.
Since EBITDA eliminates non-operational factors, it facilitates easier comparisons of companies within the same industry, providing insights into which entities are more efficient at generating profits.
Investors and lenders often use EBITDA as a measure of a company's ability to service debt, as it focuses on its cash-generating capacity. If you are applying for a business loan, lenders will calculate the EBITDA of the business to decide whether they should offer a loan and how much.
EBITDA plays a crucial role in business valuation, especially in cases where acquisition discussions or negotiations involve potential buyers or investors.

Limitations of EBITDA

While EBITDA is a valuable metric for assessing operational performance, it does have some limitations:

EBITDA ignores capital expenditures which are essential for the long-term sustainability of a business. Overlooking these expenses might lead to an incomplete understanding of a company's financial health.
EBITDA does not consider changes in working capital, which can significantly impact a company's cashflow and overall financial position.

EBITDA is a useful financial metric that offers a clear view of a company's operational profitability by excluding non-operational expenses. It allows businesses to gauge their core performance, make informed decisions, and compare themselves with industry peers. However, it is essential to consider EBITDA alongside other financial metrics to obtain a comprehensive understanding of a company's financial health.

While lenders do consider EBITDA as an important factor, it will not be the only factor in their lending decision. If you are considering calculating your EBITDA to see how much you could borrow, you could also check your business loan eligibility.