What is EBITDA in Accounting?

The understanding of key performance metrics is important in matters of accounting and financial analysis. One of the most commonly used metrics in financial analysis is EBITDA. But what is EBITDA, and why is it important? In this article, we take the EBITDA definition, how it is calculated, and explain EBITDA meaning in accounting. 

We also look at its benefits, limitations, and how it’s used as a tool for valuing businesses. Let`s start.

01 | What Is Meant By EBIDTA?

EBITDA Definition

EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a financial measure showing the profitability of a company's net income before recognizing interest expense, taxes, depreciation, and amortization. In other words, EBITDA depicts how much profitable income a company makes through core operations, excluding the traditional application of its financial and accounting policies.

EBITDA is the most common tool because it helps isolate the firm's operation performance. This aspect makes the EBITDA very helpful for comparisons between firms in an industry because it reflects only upon the abilities of the firms to make earnings out of business operations.

What EBITDA Includes

EBITDA includes all income that is gained through the operations of the company. It is a means of judging profitability from the core activity of the company, excluding financial decisions about how much debt it takes on and how it manages tax positions. It is devoid of noncash items, like the depreciation and amortization expense, which do not directly impact cash flow.

What Does EBITDA Not Include?

EBITDA does not include:

• Interest expenses: This represents the costs that the company incurs about its debt and hence is excluded from the core operation of the business. Removing interest provides the clearest view of the profitability of the business from its core activities.
• Taxes: Tax rates are very variable depending on the country or state, allowing for easier comparison between companies in different territories.
• Depreciation and amortization: These are non-cash expenses, since it reflects the aging and consumption of physical and intangible assets. Depreciation applies to tangible assets, such as buildings and equipment, whereas amortization applies to intangible ones, such as a patent or trademark.

By excluding the above elements, EBITDA focuses purely on how much profit the company derives from its core business activities.

02 | How is EBITDA Calculated?

EBITDA Formula​

EBITDA can be calculated in two popular ways. Both of them lead to the same value but start from a different financial figure.

From Operating Profit (EBIT)

The first method starts with operating profit, also known as EBIT (Earnings Before Interest and Taxes). Here’s the formula:

EBITDA=EBIT+Depreciation+Amortization

With this approach, you will take the operating profit from the income statement and add back in major non-cash expenses such as depreciation and amortization.

From Net Income

The second method starts with net income (the company’s bottom line). You then add back interest expenses, taxes, depreciation, and amortization. The formula looks like this:

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

This method is wider because it starts from net income and adjusts for all the non-operating items.

EBITDA Calculation Example

Let’s say a company has the following financial figures:

• Net income: $1 million
• Interest expenses: $200,000
• Taxes: $300,000
• Depreciation: $100,000
• Amortization: $50,000

Using the First Method (From Operating Profit or EBIT):

To calculate EBITDA using the first method (starting with operating profit), we first need to calculate EBIT (Earnings Before Interest and Taxes). EBIT is derived by adding back interest and taxes to net income:

EBIT=Net Income+Interest+Taxes

EBIT=1,000,000+200,000+300,000=1,500,000

Now, we calculate EBITDA by adding depreciation and amortization to EBIT:

EBITDA=EBIT+Depreciation+Amortization

EBITDA=1,500,000+100,000+50,000=1,650,000

This means the company’s EBITDA is $1.65 million.

Using the second method, the EBITDA calculation would be:

EBITDA=1,000,000+200,000+300,000+100,000+50,000=1,650,000

Using this method, we still arrive at the same EBITDA of $1.65 million.

03 | What Does EBITDA Tell You?

Companies use EBITDA in many ways. EBITDA is flexible because, with it, one can get views of operational performance, profitability, and cash flow generation. Below are the most common uses of EBITDA in the business world:

Comparing Profitability

EBITDA is useful in comparing companies, especially when they fall in different industries or have different capital structures. EBITDA does not include any interest payments, taxes, and depreciation, it enables analysts to assess a business without considering non-operating items. This compares favorably in the case of two companies that can have different levels of debt and hence different tax strategies.

For example, let's say the first company has a lot of debt, and the second one has zero. In such a case, comparing their net incomes would not give a proper idea regarding their operational efficiencies. However, when comparing EBITDA, you would find which company gets better profit at the operational level.

Mergers and Acquisitions (M&A)

EBITDA is used when one company wants to acquire another. In an M&A transaction, the buyer will utilize EBITDA as a means of calculating how much profit the acquired company can generate from its operations independent of its capital structure or its income tax due situation.

For instance, EBITDA can be used by an interested buyer company to gauge how well target earnings are generated from core operations. In such a case, the buyer gets to understand how well targets would perform in business once integrated into the operations of the parent company.

Internal Performance Monitoring

Companies use EBITDA to track their performance over time. Comparing EBITDA from quarter to quarter or year to year can help a company understand its core business. This helps them to find out the trend in the company's profitability and operational efficiency. For example, a firm may find that its EBITDA has increased successively for the past quarters, which could be indicative of the fact that the firm is getting more and more efficient in its operations and generating more profit from core activities.

04 | What Does EBITDA Mean in Accounting?

EBITDA has become a critical metric in accounting because it provides an quick snapshot of the operational profitability of a company. It serves as a tool to help the accountant, financial analyst, and investor view the true performance of the firm without its financing decisions, tax strategies, or accounting policies.

Quarterly and Annual Reports

Many firms will report their EBITDA figures within quarterly and annual reports. This is more common for public companies, which are obligated to release their full financial statements and data to shareholders and the public. EBITDA allows such companies to highlight their core earnings.

EBITDA and Capital-Intensive Industries

EBITDA is particularly useful in capital-intensive industries, such as manufacturing or energy, where large sums of money are usually invested in long-term assets. Because EBITDA excludes depreciation, it allows investors to focus on operational earnings without being misled by large capital outlays.

05 | Advantages and Disadvantages of EBITDA

Advantages of EBITDA

• Simplifies comparison: EBITDA, because of excluding interest, taxes, and non-cash expenses, allows easily compare to the true profitability of two different entities with different capital structures, tax strategies, or asset bases.
• Operational focus: EBITDA focuses on profitability related strictly to operations, therefore serving as a valuable tool in assessing just how well a company generates earnings from core activities.
• Valuation usefulness: Many investors use EBITDA as a base in valuation multiples (such as EV/EBITDA) to consider the value of a firm against its earnings. This is especially useful when considering mergers and acquisitions.

Disadvantages of EBITDA

• Ignores capital expenditures: Perhaps the biggest weakness attributed to EBITDA is the fact that it does not take into consideration capital expenditure, which for companies in a capital-intensive industry might be one of the largest outflows of cash.
• Can be misleading: Because EBITDA excludes critical expenses like interest and capital expenditures, it can portray the true profitability of a firm as even more favorable than it actually is. Investors should also be cautious in totally depending on EBITDA, especially in cases where the firm has appreciable levels of debt or huge capital expenditure requirements. 
• Manipulation: Since EBITDA does not account for many expenses, companies can manipulate this number to mask their financial problems. For example, a highly indebted company may highlight its EBITDA number to detract from a poor cash position or the high interest it pays.

06 | What is a Good EBITDA?

The question “What is a good EBITDA?” depends on the industry and the specific company. Different industries have different standards for what constitutes a healthy EBITDA. For example:

• Companies in capital-intensive industries, like energy or transport, could have a low relative level of EBITDA margins due to intensive asset maintenance costs. For such industries, it would be good to have an EBITDA margin of around 10-15%.
• In service-type industries or those where the level of fixed assets and capital spending is reduced, EBITDA margins of 20% to 30% or more may not be unreasonable.

Remember, a good EBITDA margin normally ranges between 10-20%, but it does have quite a connection with the industry and the size and strategy of the firm. Investors always have to relate the EBITDA margin of a company with others in the same sector to develop a more sensible view of the company's ability and performance.

07 | Software for Calculating EBITDA

Many companies make use of specialized software for tracking and calculating EBITDA. Such tools help automate this task and guarantee the abolishment of any room for error. Following is the list of some popular software solutions to calculate EBITDA:

ERP Systems

Large companies use ERP systems enacted by sellers like SAP and Oracle NetSuite. Such systems boast state-of-the-art financial reporting capabilities, which include EBITDA accounting. These ERP systems are good when a company needs to apply consolidation to the results of several departments or subsidiaries.

Accounting Software

EBITDA can be calculated quite simply using user-friendly accounting software. Te different types of accounting solutions will implement the financial data from a company and automatically develop reports, including the calculation of EBITDA. They are ideal for businesses that want a simple solution for managing their finances and tracking profitability. The special accounting software for CPA and accounting firms, like Eleven software can easily calculate EBITDA too. 

BI Tools BI

Analytical tools, like Power BI and Tableau, have now empowered organizations to develop bespoke financial reports. These applications are able to extract data from different systems, such as income statements and cash flow reports, to produce EBITDA. In addition, BI tools can help in the graphical display of a company's financial health and performance over time and/or compare EBITDA with other measures.

08 | Conclusion

EBITDA is one of the most robust tools for understanding a company's operational profitability. Its application ensures the ease with which financial comparisons become simple, main earnings are identified, and its applicability spreads in accounting and financial analysis. However, it would be apt to mention that even EBITDA has shortcomings. It does not take into account capital expenditure or debt for consideration, which may make it less effective in showing the big picture of a company's operating performance and overall financial health.

When it comes to EBITDA, consider this number in context with other metrics such as cash flow statement as net income, free cash flow, and EBIT to provide a truer, balanced picture about the financial performance of a firm.