As the acronym says, EBITDA factors in operating costs but excludes three elements of finances—taxes, depreciation, and amortization. Instead, EBITDA highlights how your company is performing in terms of earning a profit.
Benefits of EBITDA
EBITDA is one way to view day-to-day operations. It's a snapshot of current management of core expenses and future potential. Since EBITDA omits non-core financial costs and capital expenditures, it can be used to measure performance and profitability to woo investors or help you secure a business loan. It can also give insights into how a company performs compared to competitors.
The formula first gained widespread use in the 1980s as one way to measure a company's value and help investors decide whether that company would be able to pay off debt. It can be a fairer alternative to gross profit and net income, which fail to account for expenses and omit factors outside of a company's control, like higher taxes.
Limits of EBITDA
Since it does not include expenses, EBITDA differs from sharing other financial performance metrics like operating or net income. And it doesn't measure your free cash flow.
While it is a snapshot, it may be only a partial picture and give a false sense of a business's overall financial health. Information, like payments on high-interest rate loans, is left out. Some experts recommend combining EBITDA with other performance indicators for a fuller picture.
How to calculate EBITDA
There are two primary EBITDA calculations.
Net Income + Taxes + Interest Expenses + Depreciation + Amortization = EBITDA
or
Operating Income + Depreciation & Amortization = EBITDA
This information can be found as line items on either a profit-and-loss statement or a balance sheet. If you choose the second option, you can calculate operating income by subtracting operating expenses from gross income.
What are depreciation and amortization?
Some businesses calculate their EBIT, which shows net income before interest and taxes are deducted. To find EBITDA, you must also exclude depreciation and amortization.
Both depreciation and amortization are accounting techniques used to spread asset costs over several years. Instead of a single tax deduction, recurring deductions help reduce a company's tax liability over time and don't affect liquidity.
Depreciation
Assets like machines and equipment are expensive. If a fixed, physical, or tangible asset is a capital expenditure, you can recover the cost over a number of years rather than deduct the entire cost in one year. That process—an annual deduction of a portion of the cost over its useful life until fully recovered—is called depreciation. Depreciation factors in the reduction in an asset's value over time through wear and tear.
Several methods are available for recording depreciation. Two common ways are straight-line and accelerated balance. For both, the resale or salvage value is deducted from the cost. Straight-line accounting expenses are the same amount per year. A few formulas show accelerated accounting processes, with more expensed at the start and less over time.
Amortization
While depreciation covers physical assets, intangible assets are calculated over time using amortization. An intangible asset might include intellectual property, like a trademark, patent, or goodwill. Unlike depreciation, amortization often only uses the straight-line method of accounting. The straight-line method expenses the same amount each year of the asset's use. Unlike a physical asset, intangible assets don't have the same resale or salvage value.
Wait. What's goodwill? Good question! Goodwill is a catch-all category for a company's assets that aren't priced individually or monetized directly. These include elements like brand reputation, public trust, and customer loyalty. These non-qualifiable assets are particularly useful when calculating a company's value for sale.
Want to know more about financial statements like balance sheets, income statements, and cash flow statements? Head here for our primer.
Need answers to common questions about financial projections? Start here.
