EBITDA means Earnings Before Interest, Taxes, Depreciation, and Amortization. EBITDA is a significant indicator that analyzes the performance of a firm in operation. It is an approximate way of determining the cash flow generated from the overall activities of the company. There are different ways to find the value of EBITDA.
Many eCommerce business owners hear about EBITDA and wonder what it really means. The meaning of EBITDA needs to be corrected in its acronyms; as previously stated, it means earnings before interest, taxes, depreciation, and amortization. If you seek an alternative way of measuring net income, then here’s your best bet. EBITDA helps the analyst evaluate a company’s performance and profitability. Some publicly traded companies present EBITDA in their quarterly reports, which primarily excludes items such as stock-based compensation.
EBITDA is usually considered when banks need to assess the ability of a business to pay back its debt. You might approach a bank for a business loan or any other kind of finance. In that case, the bank will look at your EBITDA in order to determine whether you are capable of fulfilling your debt burdens. This approach to determining the financial health of a firm picked up momentum in the 1980s through a leveraged buyout boom.
Before measuring a company’s financial performance using EBITDA, beyond understanding just the definition of an EBITDA, it is essential to know what every abbreviated word in EBITDA means the formula stands for.
EBITDA is often used when considering asset-heavy sectors that have substantial property, plant, and equipment and, accordingly, significant non-cash depreciation expenses.
EBITDA is not as complicated as regular accounting techniques; it is equally easy to compute. In case a company doesn’t provide its EBITDA, a similar report can still be gotten quite easily from the financial statements of the company concerned. Using Excel will make this calculation relatively straightforward.
You will find the earnings, net income, tax, and interest on the income statement. At the same time, depreciation and amortization are usually provided in the notes for operating profit or inside the cash flow statement.
There are two ways to calculate EBITDA: one uses net income, and the other uses operating income, both of which would give similar results. Net income is obtained from operating income through the deduction of non-operating expenses such as taxes and interest.
The formulas for calculating EBITDA are:
D&A means Depreciation and Amortization.
EBITDA was invented by John Malone, chairman of Liberty Media, one of the few investors whose track record can match Warren Buffett’s in today’s world. During the 1980s, the players involved in leveraged buyouts needed EBITDA when evaluating companies that would be purchased to determine whether targets could support the debt load they would take on in the course of the buyout process.
Generally, EBITDA is an alternative accounting method for cash flow statements. It is a shortcut for you to fast-track appraising the value of your company and obtaining a range by multiplying it with a valuation multiple obtained from equity research, comparable companies, or industry transactions, including Mergers and Acquisitions.
When a business is not operating at a net profit, EBITDA has become a typical level of measurement among investors for reviewing company performance. Private equity firms especially love this measure, as you would, as it’s easy to compare similar businesses operating in the same industry against one another. For business owners, EBITDA helps owners tell how they compare against their competition.
There are two ways of calculating EBITDA:
Analysts commonly use EBITDA to determine firms’ operating performance. This condition indicates cash flows from the operational point of view without the influence of financial structure. Let’s assume that a company recorded a revenue of $120 million, where the cost of goods sold (COGS) was valued at $50 million and overhead expenses reached $25 million. Its depreciation and amortization were $12 million; an operating profit of $33 million was realized, and earnings before taxes of $27 million after accounting for an interest expense of $6 million. From that, you would need to subtract $6.75 million in taxes at a 25% tax rate to get a net income of $20.25 million.
EBITDA is calculated by adding back depreciation, amortization, interest, and taxes to net income. Thus, EBITDA is $45 million. This represents an explicit Indication of the core profitability of the firm before non-operating expenses, interest, tax, and non-cash charges are accounted for.
Using EBITDA is not all roses, and many eCommerce business owners face a few challenges. This is primarily because it is a non-GAAP measure, meaning that different companies have different ways of computing the EBITDA. Most companies try to emphasize their EBITDA rather than net income because it tends to reflect a company’s financial health in a far more favorable light.
Investors could be suspicious if a company that previously did not report EBITDA suddenly leads off their results with it, and you can’t blame them. It would indicate that the company might be highly indebted or that the capital and development costs are increasing. In this scenario, EBITDA could be used to mislead investors regarding the company’s actual situation.
A widespread misunderstanding of EBITDA is in the measure of cash earnings. Unlike free cash flow, EBITDA does not take into account the costs of the assets. The most significant criticism of EBITDA is that it implies profitability arises only from sales and operations, almost as if the company’s assets and liabilities were not relevant. This can leave out a lot of costs and make the enterprise appear cheaper than it may be. The reason analysts go to EBITDA multiples instead of net earnings multiples is that they often get much lower multiples.
A good EBITDA is at least double the amount of the company’s interest expenses; that is, the earnings are enough to cover debt payments with ease. Thus, if a company has $1 million in annual interest expense, for instance, it would need a higher EBITDA, meaning at least $2 million, with some extra space against financial pressure. That would show such a level of EBITDA as enabling the company to service its debt and continue its growth, something super essential either when looking for financing or assessing investment risks.
Besides, in many industries, a higher EBITDA margin is a hallmark of goodness and efficient profitability of primary business activities. However, what constitutes a good EBITDA depends on a variety of influences, including industry norms, the size of the company, its growth stage, and its financing structure.
Amortization and Depreciation are critical factors in EBITDA. Amortization in the context of EBITDA revolves around the cost of intangible assets, which is when a company gradually reduces its book value. The assets may relate to things like patents, trademarks, copyrights, and goodwill, which stands for that extra value paid during acquisition over and above their actual worth. The cost of amortization usually spreads out over the life of these assets and turns up on the income statement.
Factoring in amortization into EBITDA is essential, given that it gives a more candid picture of the actual underlying performance of a company by leaving out noncash expenses of this nature that do not actually affect its cash position. For instance, a company reliant on intellectual property would have high amortization-related costs, which then depress net income. However, EBITDA reincorporates those expenses to reveal the actual cash generation capability of the business.
With all the details above, you should be familiar with what EBITDA means. It can be utilized when comparing companies under different tax regimes and capital expenditures or in cases where changes are likely to occur in either one of these areas. Besides this, it doesn’t include non-cash depreciation charges, which may be poor indicators of future capital outlay. Contact Valleybiggs.com for guidelines for getting a proper valuation for your business.