Understanding EBITDA

What is EBITDA?

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It's a financial metric used to evaluate a company's operating performance by focusing on earnings from core business operations.

EBITDA Formula

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

Or alternatively:

EBITDA = Operating Income + Depreciation + Amortization

Why EBITDA Matters

1. Focuses on Operating Performance

EBITDA removes the effects of financing and accounting decisions, allowing you to see how well the business itself performs, regardless of its capital structure or tax situation.

2. Enables Comparison

By excluding interest, taxes, depreciation, and amortization, you can compare businesses of different sizes, capital structures, and tax jurisdictions more easily.

3. Business Valuation

EBITDA multiples are the most common valuation method for small to mid-sized businesses. A typical multiple ranges from 2-5x EBITDA depending on industry and business characteristics.

4. Cash Flow Proxy

While not the same as cash flow, EBITDA provides a good indication of a company's ability to generate cash from operations.

Breaking Down the Components

Interest

Costs related to debt financing. Excluded because capital structure varies between businesses and new owners may have different financing arrangements.

Taxes

Corporate income taxes. Excluded because tax situations differ based on jurisdiction, entity structure, and other factors unrelated to operational performance.

Depreciation

Non-cash expense that allocates the cost of tangible assets over time. Excluded because it's an accounting convention that doesn't reflect actual cash outflow.

Amortization

Similar to depreciation but for intangible assets like patents or goodwill. Also excluded as a non-cash expense.

EBITDA vs Other Metrics

EBITDA vs Net Income

Net income includes all expenses and is affected by financing, taxes, and accounting methods. EBITDA focuses purely on operational profitability.

EBITDA vs Operating Income (EBIT)

Operating income (EBIT) includes depreciation and amortization. EBITDA adds these back, providing an even purer measure of cash generation potential.

EBITDA vs Cash Flow

Cash flow from operations accounts for working capital changes, which EBITDA doesn't. However, EBITDA is easier to calculate and commonly used for quick comparisons.

EBITDA vs SDE (Seller's Discretionary Earnings)

SDE is similar but adds back owner's salary and discretionary expenses. It's more commonly used for smaller businesses where the owner is heavily involved.

EBITDA Example Calculation

Sample Income Statement:

Revenue: $2,000,000
Cost of Goods Sold: $800,000
Gross Profit: $1,200,000
Operating Expenses: $600,000
Depreciation: $100,000
Amortization: $50,000
Operating Income (EBIT): $450,000
Interest Expense: $80,000
Earnings Before Tax: $370,000
Taxes (25%): $92,500
Net Income: $277,500

EBITDA Calculation:

Net Income: $277,500
+ Interest: $80,000
+ Taxes: $92,500
+ Depreciation: $100,000
+ Amortization: $50,000
= EBITDA: $600,000

EBITDA Margins

EBITDA margin is calculated as EBITDA divided by revenue. It shows what percentage of revenue converts to operating profit.

EBITDA Margin = (EBITDA / Revenue) × 100

Using our example: ($600,000 / $2,000,000) × 100 = 30% EBITDA Margin

Industry Benchmarks

SaaS/Software: 20-40%
Manufacturing: 10-20%
Retail: 5-15%
Restaurants: 10-15%
Professional Services: 20-30%
E-commerce: 5-20%

Using EBITDA for Valuation

Business valuations often use EBITDA multiples. The multiple depends on:

Industry and sector
Company size
Growth rate
Customer concentration
Market conditions
Competitive advantages

Valuation Example

If a business has EBITDA of $600,000 and the industry multiple is 3.5x:

Business Value = $600,000 × 3.5 = $2,100,000

Limitations of EBITDA

1. Ignores Capital Expenditures

EBITDA doesn't account for the cash needed to maintain or replace assets. A business might have strong EBITDA but require significant ongoing capital investment.

2. Doesn't Reflect Working Capital Changes

Growth often requires increased working capital (inventory, receivables). EBITDA doesn't capture these cash requirements.

3. Can Mask Debt Issues

By excluding interest, EBITDA can make highly leveraged companies look better than they are. Always consider debt levels separately.

4. Non-GAAP Measure

EBITDA isn't a GAAP (Generally Accepted Accounting Principles) measure, so companies may calculate it differently. Always verify the calculation method.

5. Quality of Earnings

EBITDA doesn't distinguish between sustainable and one-time earnings. Always analyze the components to ensure quality.

Adjusted EBITDA

Many business valuations use "Adjusted EBITDA" which adds back:

One-time expenses (litigation, restructuring)
Owner's excessive salary
Personal expenses run through the business
Non-recurring costs
Below-market rent (if owner owns the property)

Key Takeaways

EBITDA measures operational profitability without financing and accounting effects
It's the primary metric used for small business valuations
EBITDA multiples typically range from 2-5x depending on industry
Higher EBITDA margins indicate better operational efficiency
Always use EBITDA alongside other metrics like cash flow and net income
Verify what's included in EBITDA calculations - adjustments matter