Pehr Gyllenhammar, former CEO of Volvo, is credited in 1988 with the expression “Revenue is vanity, profit is sanity”.
When it comes to evaluating the financial performance of a business, there are several key metrics you can use. EBIT and EBITDA are very similar profitability measures, although EBITDA is the measure which investors and lenders often use to value companies or assess their ability to repay debts. By understanding and using EBITDA, you can gain a deeper understanding of your business’s financial performance and make informed decisions to drive growth and success.
In this article, we’ll explain what EBITDA is, why it’s used, how to calculate it, and more.
What is EBITDA?
EBITDA, pronounced "ee-bit-dah", is one of the most commonly used metrics for evaluating a business’s financial health and ability to generate cash flow. Lenders typically use EBITDA to determine a company’s ability to repay its debts, and investors often use it as a valuation metric to assess a business’s worth.
What does EBITDA stand for?
EBITDA stands for “earnings before interest, taxes, depreciation and amortisation”. By removing the variables of tax, depreciation, amortisation, and interest, you get a better picture of a company’s performance and growth potential, and can more accurately compare one business to another.
How to calculate EBTIDA
To calculate EBITDA, you start with the business's net income (earnings) then add back interest expenses, taxes, depreciation, and amortisation. Here's the formula for EBITDA calculation:
EBITDA = Net Income + Interest Expenses + Taxes + Depreciation + Amortisation
Let’s break down each element:
- Earnings refers to the net income your business generates. This is the total revenue you earn from sales minus the business costs you incur over a specific period. It’s the bottom-line figure on the income statement
- Interest refers to the cost of borrowing funds. It includes interest payments on loans, credit lines, or other forms of debt
- Tax expenses include income taxes or other tax liabilities that the business is required to pay for the year
- Depreciation represents the loss in value of tangible assets, such as vehicles and machinery, over time
- Amortisation is similar to depreciation but applies specifically to intangible assets, such as intellectual property, which eventually expire
You can find each line item in the EBITDA calculation on your company’s income statement, also known as the profit and loss statement.
By adding back financing expenses (interest), taxes, and the major non-cash expenses (depreciation and amortisation), EBITDA allows for a clearer assessment of a business's core profitability and operational performance.
Adjusted EBITDA
Adjusted EBITDA is similar to EBITDA but makes further adjustments to get a clearer picture of a company’s true profitability and operating cash flow. Analysts and investors often use it for valuation purposes. The adjustments that are either added back or subtracted can vary depending on the industry, company, and specific circumstances, but some common adjustments include:
- Unrealised gains or losses
- Non-cash expenses
- Non-operating income
- One-time gains or losses
- Litigation expenses
- Gains or losses on foreign exchange
- Goodwill impairments
- Share-based compensation
The formula for calculating adjusted EBITDA is:
Adjusted EBITDA = EBITDA +/- Adjustments
EBIT
EBIT stands for “earnings before interest and tax”. While EBITDA is more commonly used and preferred when comparing companies with a large number of fixed assets, it does completely ignore CapEx (capital expenditure). Therefore, for those businesses that are asset intensive, EBIT is generally the better measure to use.
Methods of valuing a business
There are a number of ways to value a business. We won’t go into them in detail in this article, but these are a few of the methods you could use:
- Market capitalisation – generally used for listed businesses
- Asset/book value – used for asset rich businesses
- Discounted cash flow
- Revenue/income method - generally used for technology businesses
- Earnings multiplier – see below
EV/EBITDA
The EV/EBITDA multiple is a financial ratio that’s commonly used to value companies. EV stands for Enterprise Value, which represents the total value of a company, including its debt and equity. The EV/EBITDA multiple is calculated by dividing the enterprise value by the EBITDA.
The main purpose of the EBITDA multiple is to provide investors and analysts with a comparative valuation of companies, helping them to assess a company's overall worth in relation to its earnings and gauge its attractiveness as an investment opportunity.
