What Is EBITDA?

EBITDA is an acronym that stands for “earnings before interest, taxes, depreciation, and amortization.” It’s a business metric used to assess a company’s financial health and ability to generate cash.

In this guide, we’ll break down the components of EBITDA, how to calculate it, and when this key metric can come in handy for your small business.

What is EBITDA?

EBITDA is often used as a way to gain insight into a company’s cash flow. Let’s break down the different components to understand what EBITDA can indicate:

• Earnings: the amount of money your business earns over a certain period (usually months or quarters).
• Interest: the extra money you pay to lenders on top of the initial principal amount you borrowed.
• Taxes: any local, state, or federal taxes you paid as part of your business activities.
• Depreciation: the gradual reduction in value of existing, tangible assets such as equipment, inventory, or other capital expenditures.
• Amortization: the gradual reduction in value of intangible assets, such as reductions in loan payments or the worth of proprietary software.

EBITDA is used to indicate a company’s financial performance and profitability. “Stripping away extraneous factors such as interest, taxes, depreciation and amortization (the last four letters in the acronym) from total earnings provides a clearer, more accurate measure of a company’s cash flow—especially compared with that of competitors,” wrote Chase for Business.

Note that EBITDA is not a GAAP or IFRS-approved metric, and some investors are wary of using this measurement. EBITDA’s limitation is that it presents the company as if the business has never paid any interest or taxes. For accounting purposes, it’s not always the most accurate depiction of your company’s financial position. Instead, it’s best as a benchmark against your competitors and others in your industry.

[Read more: What is a Business Valuation and How Do You Calculate It?]

How to calculate EBITDA

EBITDA can be found using the following calculation:

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

An alternative option is to start with your operating profit, which captures your net income, interest, and taxes. To simplify, EBITDA = Operating Profit + Depreciation + Amortization.

Once you know your EBITDA, you can measure your results against similar businesses in your industry. What qualifies as a “good” EBITDA varies based on your business expenses, cash flow, and specific industry. “The EBITDA ratio varies by industry, but as a general guideline, an EBITDA value below 10 is commonly interpreted as healthy and above average by analysts and investors,” wrote the BDC.

However, the EBITDA margin formula gives you a way to evaluate your business’s EBITDA. The margin formula is:

EBITDA Margin = EBITDA ÷ Total Revenue

For example, if your EBITDA is $500,000, and your total revenue is $5,000,000, your EBITDA margin is 10%.

“Publicly traded companies have average EBITDA margins in the low teens, though they vary widely by industry,” wrote Chase for Business.

[Read more: Concerned About Your Business's Financial Health? Here Are 6 Methods for Measuring Profitability]

When to use the EBITDA calculation

EBITDA is commonly used by businesses, valuators, bankers, and investors to understand a company’s profitability, performance, and valuation.

EBITDA’s main use is in business valuations. Potential investors use EBITDA to compare similarly sized businesses within a specific industry. EBITDA allows investors and valuators to compare one company’s value with its raw earnings in order to make better acquisition decisions.

Likewise, this metric is also used to assess risk. “Banks and other lenders often consider your company’s EBITDA when deciding whether your business is a risk they’re willing to take on,” wrote Chase for Business. “EBITDA is used to determine a company’s debt service coverage ratio, which shows potential lenders how well you’ll be able to repay the loan and meet other short-term obligations.”

For your own purposes, EBITDA removes some of the variable costs that can make it difficult to assess your business success. Taxes, interest payments, and depreciation all change from one year to the next. EBITDA allows you to compare your company’s raw earnings over time, giving you a clearer picture of your position in the market.

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