What is EBITDA?

EBITDA is a measure of how much profit your business makes from its core trading activity, before interest, tax, depreciation and amortisation are taken into account. It strips out the costs that depend on how a business is financed, taxed or has chosen to account for its assets, so you can see how the underlying business is actually performing.

Business owners, lenders and investors all use EBITDA because it makes it easier to compare businesses on a like for like basis, whatever their financing structure or tax position happens to be. Below, we cover what EBITDA stands for, the formula, a worked example, what a good EBITDA margin looks like, and how EBITDA is used to assess funding and value a business.

What does EBITDA stand for?

EBITDA stands for earnings before interest, taxes, depreciation and amortisation. Each part strips out a specific cost that can vary from one business to the next for reasons that have nothing to do with day to day trading performance.

• Earnings. Your net profit, the starting point before anything is added back.

• Before interest. Interest paid on loans, overdrafts or credit facilities is left out, since two businesses that trade identically could carry very different levels of debt.

• Taxes. Corporation tax is added back, since tax rates and reliefs vary and do not reflect operating performance.

• Depreciation. The gradual reduction in value of physical assets, such as machinery or vehicles, is added back, since it is an accounting entry rather than actual cash leaving the business.

• Amortisation. The equivalent gradual write down of intangible assets, such as goodwill or patents, is added back for the same reason.

What is the EBITDA formula?

There are two ways to arrive at the same EBITDA figure, depending on which numbers you already have to hand from your accounts.

• From net profit: EBITDA = net profit + interest + tax + depreciation + amortisation

• From operating profit: EBITDA = operating profit (EBIT) + depreciation + amortisation

The second version is often quicker if your management accounts already show operating profit, since interest and tax have already been removed to arrive at that figure.

How do you calculate EBITDA? A worked example

Say a professional services business reports the following figures for the year in its accounts.

Starting from a net profit of £96,000, adding back the costs of financing, tax and non cash accounting adjustments gives an EBITDA of £180,000. That figure reflects what the business generates from trading alone, before those other factors come into play.

What is EBITDA margin, and what counts as good?

EBITDA margin shows what percentage of your revenue converts into EBITDA, and it is calculated as EBITDA divided by revenue, multiplied by 100. In the worked example above, a business with revenue of £850,000 and EBITDA of £180,000 has an EBITDA margin of around 21 percent.

There is no single good EBITDA margin, since typical margins vary greatly by industry. A 21 percent margin is strong for a manufacturer but only middling for a software business, so it is worth judging your margin against similar businesses in your own sector rather than a general rule of thumb.

These are broad guides rather than fixed rules, and the trend in your own margin over time often matters more than the number itself. A business that improves its margin from 8 to 14 percent over a few years is usually in a stronger position than one that has stayed flat at 18 percent with no growth.

What is adjusted EBITDA?

Adjusted EBITDA takes the standard EBITDA figure and strips out costs that will not recur or do not reflect how the business would run under normal ownership. It is most often used when a business is preparing for sale, investment or a funding application, since it gives a clearer view of ongoing, repeatable earnings.

Common adjustments include:

• Above market owner salary or benefits that a new owner would not need to pay at the same level

• One off legal, restructuring or relocation costs

• Non recurring bad debts or insurance claims

• Rent paid to a connected party at above or below market rate

• Costs tied to a one off project or contract that will not repeat

Because adjusted EBITDA relies on judgement calls about what genuinely will not recur, it is worth being able to justify every adjustment with evidence, particularly if the figure is being used to support a valuation or a funding application.

Is EBITDA the same as net profit or operating profit?

EBITDA, operating profit and net profit are all measures of profitability, but each one strips out a different set of costs, so they answer slightly different questions.

EBITDA sits above both operating profit and net profit on your income statement, which is why it is usually the largest of the three figures. None of them is more correct than the others, they simply answer different questions about how a business is performing.

Is EBITDA the same as cash flow?

EBITDA is not the same as cash flow, even though the two are sometimes confused. EBITDA is a measure of profit that adds back non-cash costs like depreciation and amortisation, but it does not account for tax and interest actually paid, or for cash tied up in stock, debtors and creditors. A business can report healthy EBITDA while still being short of cash if customers are slow to pay or a lot of cash is tied up in working capital. For a figure that reflects real cash movement rather than adjusted profit, operating cash flow is the more accurate measure to look at alongside EBITDA.

Why do lenders look at your EBITDA?

Lenders use EBITDA to work out debt service capacity, essentially whether your business generates enough underlying profit to comfortably cover loan repayments alongside its other costs. A healthy and stable EBITDA gives a lender more confidence that repayments will be met even if interest rates or tax positions change.

Your EBITDA and margin trend also sit alongside your business credit score as part of how lenders assess risk, and both are worth keeping in good shape before you apply for funding. If you want to see what your numbers could mean for what you can borrow, our guide to business loan eligibility covers the other factors lenders weigh up alongside your financials.

How is EBITDA used to value a business?

EBITDA is one of the most common starting points for valuing a business, particularly for mergers, acquisitions and investment. Valuers apply a multiple to EBITDA to arrive at an estimated enterprise value, so a business with an EBITDA of £500,000 and an agreed multiple of 5 would be valued at roughly £2.5 million.

The multiple applied varies hugely by industry, growth rate and how established the business is, but as a broad average, private company sales tend to sit closer to 4 times EBITDA, compared with an average nearer 8 times EBITDA for larger, publicly listed companies. A business that is growing quickly, has recurring revenue or operates in a sector investors favour will usually attract a higher multiple than one of these broad averages suggests. If you are on the other side of that transaction and looking to fund an acquisition, our guide to getting a loan to buy a business covers how that kind of finance works and what lenders expect to see.

What are the limitations of EBITDA?

EBITDA is a useful shortcut, but it has some real blind spots that are worth understanding before you rely on it too heavily.

• It ignores capital expenditure, so a business that needs to spend heavily on equipment or vehicles to keep operating can show a healthy EBITDA while still needing significant reinvestment

• It does not reflect changes in working capital, so it can look strong even while cash is building up in unpaid invoices or stock

• It is not a measure defined under UK GAAP or IFRS, so two businesses can calculate it slightly differently, making comparisons less reliable than they first appear

• A business can report positive EBITDA while still making a loss or running short of cash once interest, tax and reinvestment are factored in

• Adjusted EBITDA in particular relies on judgement calls about what counts as one off, which can be used to present a more flattering picture than the underlying business supports

Because of these gaps, EBITDA works best alongside other measures, such as net profit, operating cash flow and your balance sheet position, rather than as a single number to judge a business by.

How can you improve your EBITDA?

Improving your EBITDA means growing the profit your core trading generates, rather than simply growing revenue. A few areas tend to make the biggest difference:

• Review pricing regularly, since even a small increase often adds straight to EBITDA without a matching rise in costs

• Renegotiate supplier contracts and buy better on your largest cost lines, rather than spreading effort across every small expense

• Cut costs that do not directly support revenue or customer service, rather than reducing spend across the board

• Focus growth on your higher margin products, services or customers rather than chasing revenue that adds little to the bottom line

• Automate repetitive admin and finance tasks to reduce overheads as the business grows, rather than adding headcount for every increase in volume

Looking for funding?

A healthy, growing EBITDA puts you in a stronger position when you come to apply for finance, whether that is to fund growth, buy equipment or acquire another business. At Capitalise we work with a panel of 130+ UK lenders, so you can check your business credit score, see how much you could borrow, then apply for business finance all in one place. Apply today to get started.