EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Just saying all of those words out loud can feel overwhelming. But by following a simple step-by-step calculation, EBITDA can tell startup owners and potential investors a lot about the state of a business. While startups should look at a variety of different measurements for a complete picture, EBITDA is an important calculation to master.
Whether you’re already feeling lost or looking for a way to simplify calculating EBITDA, we’ll walk you through the ins and outs below.
What is EBITDA, And Why It Matters?
EBITDA is a financial calculation used to determine a company's earning potential and profitability.
As a stand-alone, EBITDA sheds light on the company’s ability to generate income solely from its core operations rather than net income alone. But it is most frequently used amongst investors to analyze and compare profitability between different corporations and industries regardless of size, taxes, assets, or structure — to even the playing field, so to speak.
Overall, EBITDA is a quick and dirty way to calculate the ballpark value of a startup. Still, most financial advisors will always recommend conducting a more thorough evaluation and valuation of a company as many factors play a role in its actual value. The type formula used to calculate EBITDA also plays a role (more below) as there are no official regulations around these EBITDA calculations.
Important Definitions To Understand Before Calculating EBITDA
As previously mentioned, EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Let’s break down each piece of the EBITDA acronym.
- Earnings — Your company’s income or profit.
- Before — This implies that you exclude certain items from your operational performance, all of which follow in the next four parts of the EBITDA acronym.
- Interest — The interest of a company depends on its financial structure — how much you borrowed and at what interest rate. So, we exclude this piece.
- Taxes — Taxes heavily vary based on the location of a business, so this also gets excluded from the EBITDA calculations.
- Depreciation & Amortization — We’ve lumped these together because they are both fixed costs, meaning they do not change over time or based on the number of customers or “units” sold. Instead, your investments and the number of years you use those assets drive depreciation and amortization, not the current operating performance. Further, amortization is an accounting technique used to periodically lower the book value of intangible assets over a set period. Think intellectual property such as patents or trademarks. Depreciation does the same for tangible assets such as owned equipment, vehicles, or salaries.
Finding EBITDA On Your Financial Statements
To add more context, it’s essential to understand where EBITDA falls into the three types of financial statements:
- Balance Sheet — Gives an overview of what the business owes and owns or its assets and liabilities.
- Income Statement – Shows the profit and income generated during a specific period; also calculated using Revenue -/- Expenses and Sales -/- Costs.
- Cash Flow Statement – Outlines how much cash the business generates and where it gets spent.
EBITDA falls into all of this as an income statement metric.
How To Calculate EBITDA
There are two different formulas used to calculate EBITDA. One starts with operating income as its base, and the other begins with net income. Each may produce different results. But as long as you use the same formula year over year, you should have a good idea of your company's value and evaluate growth over time.
- Formula 1 = Operating Income + Depreciation & Amortization
This variation of the EBITDA formula shows a company's profit after subtracting the business's daily operating costs. It also does not include interest and taxes. You may have also heard of EBIT (more on EBIT here), where you would stop here in the formula and not proceed with factoring depreciation and amortization. Typically more service-based businesses will follow this method as they do not hold many, if any, fixed or intangible assets.
- Formula 2 = Net Income + Taxes + Interest Expense + Depreciation & Amortization
Essentially, this formula is the first in reverse. A company would start with net income and add everything back in to determine operating income. Again, the two calculations might show different end totals since a company’s net income includes items not usually included in operating income. An example of this would be a one-time expense, such as hiring a designer to create a company logo.
How Does EBITDA Compare To Operating Income?
We just learned that EBITA is an income metric. But is that different than Operating Income? Yes!
While both EBITDA and Operating Income indicate company profits, EBITDA shows the profit, including the interest tax depreciation and amortization. Operating Income tells us the profit after taking into account the operation expenses (depreciation and amortization) — a direct calculation with no adjustments made, such as with EBITDA.
Both calculations are useful in different ways. You should use operating income to find how much of your revenue you can convert into profit. In other words, it is the amount of profit gained through company operations. Alternatively, investors and private equity players use EBITDA to calculate the earning potential of a company.
We find Operating Income with an equation quite different from EBITDA:
- Operating Income = Gross Income (Net Sales -/- Cost of Good Sold) -/- Operating Expenses
Additionally, EDBITA is not an official GAAP measurement. Operating Income is a GAAP measurement, so no adjustment can be made to the calculations.
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