What is EBITDA? Why It's Important

In the world of finance and accounting, EBITDA is a key metric to help evaluate a company's financial health and operational efficiency. By setting aside the effects of financing decisions, tax environments, and accounting practices, this metric offers a clearer view of a business's core profitability.

Business owners and investors rely on EBITDA to assess a company's value, compare its performance against industry benchmarks, and understand its capacity to generate cash from operations.

In this article, we’ll go through what EBITDA is in more detail, including both its benefits and drawbacks in evaluating a company’s profitability.

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Table of contents
What is EBITDA in finance? Save Time and Money On Overseas Payments With Wise Business The importance of understanding EBITDA How do you calculate EBITDA? What is Adjusted EBITDA?

What is EBITDA in finance?

EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It’s a financial metric that’s used to evaluate a company’s financial performance by focusing on its core profitability.

To understand EBITDA, it’s worth comparing it to another metric that’s used to assess a company’s profitability—net income. You can calculate net income by subtracting all expenses, including operating costs, taxes, and interest, from a company's total revenue.

EBITDA takes a different approach to evaluating profitability. As its name implies, it adds back interest, taxes, depreciation, and amortization from a company’s net income. By not considering the impact of interest, taxes, depreciation, and amortization, many investors argue that EBITDA provides a better sense of whether the company’s core activities are actually profitable or not.

While there are many benefits to using EBITDA when evaluating a company’s financial status, it’s worth mentioning that you may not come across it on a company’s income statement. To date, EBITDA actually hasn’t been recognized under the US generally accepted accounting principles (GAAP).

Also, many finance and accounting professionals have criticized EBITDA for overstating the profitability of companies. To address these discrepancies, the U.S. Securities and Exchange Commission (SEC) currently requires companies to reconcile EBITDA figures with net income in financial reports.

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Operating Cash Flow vs EBITDA

Operating cash flow (OCF) serves a different purpose than EBITDA and provides distinct insights into a company’s financial health. While both metrics add back depreciation and amortization, OCF includes the effects of interest and taxes, which EBITDA excludes.

As a result, OCF reflects the actual amount of cash generated by a company's normal business operations. Unlike EBITDA, this metric accounts for changes in working capital, reflecting real cash movement within the business.

Operating cash flow is considered to provide a more accurate picture of a company's ability to generate cash to maintain and grow its operations. It provides a deeper understanding of a company's liquidity and operational efficiency when compared to EBITDA.

The importance of understanding EBITDA

EBITDA is important for anyone involved in business, from investors to company owners. This financial metric offers valuable insights into a company's operational profitability by focusing on core business performance, which can be used to better understand a company’s overall value.

While EBITDA has its limitations, it remains a widely adopted tool for assessing financial health, comparing companies across industries, and making more informed business decisions. Let’s explore its significance for different stakeholders and see how it contributes to understanding a company’s overall financial position.

What EBITDA means for investors

For investors, EBITDA is a great way to understand a company’s operational profitability and make more informed decisions with their money.

This metric allows investors to assess a company's core performance without the influence of financing decisions, tax environments, or accounting practices related to long-term assets. As a result, it provides a much clearer look at the profitability of the business’s core operations.

In addition to deepening their understanding of a company’s value and growth prospects, EBITDA also helps investors see how businesses compare with each other. Since this metric is standardized across various industries and geographies, it’s an easy way to compare performance and evaluate which business offers a greater value.

What EBITDA means for financial institutions

For financial institutions, EBITDA can be used to assess a company's creditworthiness. This metric can be particularly important when considering whether a business can support a potential loan, line of credit, or mortgage since it provides lenders with insights into a company's ability to meet its financial commitments.

By stripping away factors outside the company’s control, like interest, taxes, depreciation, and amortization, EBITDA helps financial institutions determine a business's overall ability to generate cash flow and service its debt obligations. As a result, it’s frequently used in debt covenants and credit analysis.

What EBITDA means for business owners

Business owners can use EBITDA to get a clearer picture of their company’s operational performance and profitability. Since this metric focuses on core business activities, it’s an especially useful way to understand what works and what doesn’t. Business owners can leverage this key information to identify areas for improvement within their day-to-day operations.

As we’ve seen, potential investors and creditors are likely to consider a company’s EBITDA when determining its overall value. As a result, it’s important for business owners who are considering mergers, acquisitions, loans, or outside investment.

By understanding and optimizing their EBITDA, business owners can demonstrate their company's worth to potential buyers and investors. From there, they can leverage their position to set their company up for future growth and success.

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How do you calculate EBITDA?

Two equations are used to calculate EBITDA. The first starts with a company’s net income, while the second is based off of operating income.

It doesn’t matter which equation you use—both should arrive at what is essentially the same result. You might want to look into hiring an accountant to help you calculate EBITDA as accurately as possible.

EBITDA = Net Income + Taxes + Interest + Depreciation & Amortization

or

EBITDA = Operating Income + Depreciation & Amortization

Let’s take a look at some examples of how to calculate EBITDA. By including examples with both positive and negative net income, we can see how EBITDA’s ability to set aside factors outside a company’s control can be useful in evaluating its core operations.

Example #1: Eddie’s Electric

For our first example, let’s consider a company called Eddie’s Electric. It reported the following financial data for a fiscal year, with a net income of $450,000 and $10,000 in amortization and depreciation expenses:

• Net Income: $450,000
• Interest Expense: $20,000
• Taxes Paid: $190,000
• Depreciation Expense: $5,000
• Amortization Expense: $5,000

EBITDA = $450,000 + $20,000 + $190,000 + $5,000 + $5,000 = $670,000

Eddie's Electric would report an EBITDA of $670,000, representing its earnings from core operations before accounting for non-operational expenses.

Example #2: Jimmy’s Jewelry

As a point of comparison, let’s consider a company with a negative net income of $5,000.

• Net Income: -$5,000
• Interest Expense: $2,000
• Taxes Paid: $4,000
• Depreciation Expense: $500
• Amortization Expense: $0

EBITDA = -$5,000 + $2,000 + $4,000 + $500 + $0 = $1,500

By setting aside the elements outside of the company’s direct control, including interest and taxes, Jimmy’s Jewelry shows a positive EBITDA of $1,500. This indicates that the core operations of the business were actually profitable before accounting for interest, taxes, and depreciation.

What is Adjusted EBITDA?

Adjusted EBITDA starts with the standard EBITDA calculation, then takes it a step further by also accounting for non-recurring items such as restructuring costs, one-time settlements, gains or losses from asset sales, and stock-based compensation.

By adjusting for these irregular expenses, adjusted EBITDA provides a more normalized view of what the company's earnings would look like under typical operating conditions. It’s meant to give investors a better understanding of the company’s core performance by setting aside any unusual events that aren’t reflective of its ongoing operations.

Of course, in many instances, this metric also allows companies to present their financial performance in a more favorable light. Since there isn’t one standard formula for adjusted EBITDA, different companies are able to adjust for different things under different circumstances.

So, while this metric can be a useful way to look at the profitability of a particular business and compare it with others in the industry, it should be considered alongside other financial metrics to increase overall transparency and accuracy.

EBITA vs EBITDA

EBITA stands for earnings before interest, taxes, and amortization. Much like EBITDA, it’s a financial metric used to understand a company’s profitability and financial performance over a given period of time that falls outside of generally accepted accounting principles (GAAP).

These metrics differ in how they treat depreciation expenses. EBITDA excludes both depreciation and amortization, while EBITA only excludes amortization but includes depreciation.

While EBITA isn’t as commonly used, it’s still considered a useful metric, especially for companies with minimal capital expenditure. Since these companies don’t have substantial investments in fixed assets, it’s able to provide a more conservative and, therefore, more accurate measure of profitability.

EBIT vs EBITDA

EBIT refers to earnings before taxes and interest. It’s another way to examine a company’s operational performance, though it handles depreciation and amortization differently than EBITDA.

While EBITDA includes depreciation and amortization expenses, EBIT excludes them. Treating cash expenses in this way is ideal for companies with substantial investments in fixed assets financed by debt. That said, it does run the risk of overestimating a company’s profitability by excluding key costs like asset replacement and interest.

EBIT is more widely reported than EBITDA. Not only is it accepted under GAAP standards, but it’s also considered to offer a clearer picture of operational efficiency by including depreciation and amortization. Highly leveraged organizations with good operating earnings are likely to include it in their financial statements.

EBT vs EBITDA

Earnings before taxes (EBT) focuses on profitability before taxes, including all operational and non-operational expenses except for taxes. It’s useful for comparing companies across different tax jurisdictions by removing the impact of tax strategies.

On the other hand, EBITDA provides a broader view of operational performance by excluding not only taxes but also interest, depreciation, and amortization expenses. As a result, it’s often preferred for evaluating companies with significant investments in fixed assets or those financed by debt.

While EBITDA can provide a more standardized comparison between companies across industries, since it excludes substantial expenses affecting cash flow, it can also sometimes give a misleading impression of financial health.

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