Understanding the Basics of EBITDA
When it comes to considering your business or company’s finances, EBITDA is one term you want to be aware of and understand. In the simplest of forms, EBITDA is a measurement of a company or business’s overall financial performance. Many financial officers often prefer looking at the EBITDA as it offers a much more accurate view of the business or company’s profits and losses.
- 1 Understanding the Basics of EBITDA
What is EBITDA?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Don’t be deceived by this long acronym; it isn’t as daunting or complicated as it seems.
To best understand EBITDA, here is a breakdown of the letters and what exactly they mean.
Earnings Before Interest
Sometimes abbreviated as EBIT, it is the indicator that looks at the company or business’s earnings. This dollar amount appears before taxes or interests are deducted from the overall amount. The best way to look at EBIT is that it is the number that indicates whether the company or business is operating with a profit or a loss.
EBIT is important as it allows the company or business to manage its operational costs and plan for the future. It is also important as it can provide insight into the profit trends for the company or business.
Depending on which state the business is located in, there are different levels of taxes to factor in. There are state and federal taxes, and if you have a business that is located across multiple states, that can complicate things. Nonetheless, when it comes to EBITDA, the taxes look at taxes you need to factor including and not including; for example, when you are calculating payroll, the taxes calculated are considered operation; therefore, you include that as part of your expenses.
Looking at depreciation from a financial perspective is to look at the business or company’s value and use of its assets over a period of time. Often depreciation is associated with physical and tangible assets; however, depreciation can also happen to intangible assets as well.
Depreciation can impact a company or business’s worth if the value reaches zero.
When it comes to working with businesses or company’s, there are often large sums of money that are being dealt with, whether the amount is coming or going. Amortization is one way of spreading out the amount over a set period of time. This practice is often applied when determining a payback plan for a loan.
Though there is no official requirement to provide the EBITDA, a simple formula can be followed to calculate the EBITDA.
The standard formula that is used when calculating EBITDA is:
Net income + Interest + Taxes + Depreciation + Amortization
Company’s or businesses can find themselves in either a positive or negative EBITDA, which for the most part, most companies do experience being on the lower end of the EBITDA. Being in the negative on occasion does not necessarily dictate whether a company or business is going to fold. Awareness of the financial standings early on can help prevent any further financial operations shortcomings. Paying attention to the EBITDA is practicing proper due diligence, as it’s better to be aware if the numbers do not line up or if the losses are more significant than the profits.
Another version of the EBITDA formula is:
Operating profit + Depreciation Expense + Amortization Expense
Why Is EBITDA Calculated?
Investors, or anyone looking to assess or determine the value of a company or business, are going to use the EBITDA formula. The number concluded to at the end helps determine whether a business or company is profitable in the long run or not excelling in profits.
Another reason that EBITDA calculations can be used is when financial institutions determine whether or not to loan money to the business or company. The calculation of EBITDA can help them understand their risks and liabilities. In many instances, EBITDA is a consistent indicator of the company’s value and ability to repay or pay down debts.
Advantages and Disadvantages of EBITDA
The success or shortcomings of a business do not always come from looking at the bottom line; however, the dollar figure on that line does help provide a glimpse into whether or not one can continue to operate or if changes need to be made.
Despite some believing that EBITDA does not provide a proper or full scope of a business or company’s actual value, some advantages that should be considered are:
- Provides an overall view and understanding of how the business or company is doing.
- Focuses solely on the numbers that matter – day-to-day operations and expenses.
- Allows for the big-picture image of profits or losses.
- Great tool for comparison against other businesses in the same field or niche.
A few things to consider when calculating a business or company’s EBITDA that may actually be a disadvantage include:
- Cost assets are not included – focuses solely on sales garnered.
- The starting value can vary, which may not always provide a clear or objective count.
- It does not factor in the working capital or the equipment which adds to a business or company’s value which can sway the numbers.
- May minimize a business or company’s actual worth; therefore, resulting in its undervaluing.
At the end of the day, there is nothing that forces a business or company to have to calculate their EBITDA; however, the information that comes from it can be a great tool and asset. Companies looking to buy out other companies or investors looking to invest often refer to the EBITDA to see whether that company is worth buying or investing in.
Financial Literacy Begins with Knowing Your Vocabulary
Taking the time to understand terminology such as EBITDA, how it is calculated, and how it impacts you is one way of controlling your understanding of money. Being informed on concepts such as EBITDA allows one to make informed and sound judgments on how to spend, save, or balance their finances.