What does the EBITDA formula mean in practice?

Revolut Contributor

 · August 03, 2020  · 08/03/2020

The EBITDA formula is a profit metric that is often used to examine the financial performance of a business. This unconventional metric excludes several categories of costs that the business would otherwise deduct from its total revenue over a given period when it calculates net profits.

The name EBITDA (pronounced EE-BIT-DAH) is an acronym that stands for Earnings Before Interest, Tax, Depreciation and Amortisation. The basic principle is that the metric reveals the profits that a business would have made if it didn’t subtract all these various categories of costs from its revenue.

Proponents say that by ignoring ‘non-cash’ expenses, such as the depreciation of long-term assets and costs which are unrelated to everyday business operations (i.e. interest and taxes), the EBITDA metric provides insights into the underlying financial performance.

How do you calculate EBITDA?

There is no statutory definition, and the metric is not covered by the UK’s Generally Accepted Accounting Practice (GAAP) guidelines, which makes this a grey area. Even so, there is an agreed method for the EBITDA calculation. Unlike most profit metrics, this one isn't typically worked out from revenue directly. Instead, when faced with the challenge of how to calculate EBITDA, it's more common to take the net profit figure and then add-back specific costs, which are shown on the income statements of the business.

EBITDA = Net profit + [Interest + Tax + Depreciation + Amortisation]

What is a good EBITDA ratio?

It's easy to convert the monetary value of this metric into a ratio, which is called the EBITDA margin, and doing so makes it easier to compare businesses of different sizes. The answer reveals how much profit a business creates for each pound it takes in revenue over a period, once it allows for the costs that are part of the EBITDA calculation. We cover EBITDA margin this in detail here and the formula is below.

EBITDA margin = (EBITDA/Revenue) x100

Like most financial metrics, it's more sensible to compare this margin figure to the same metric from earlier periods, a forecast, or an industry benchmark than to define one arbitrary value as 'good'.

What does EBITDA mean in business?

Advocates of this metric suggest that it reveals whether a business is profitable without, what they refer to, as the distorting effects of factors that managers have little control over. These include the taxes due, interest on loans, and the ‘non-cash’ sums provided in the accounts to reflect the falling or impaired value of long-term equipment (i.e. depreciation) and intangible assets like goodwill or patents (i.e. amortisation). It’s fair to say these last two categories are handled in a subjective way – e.g. the number of years they are spread over – and the lack of open markets for intangibles makes them tricky to value. Some people argue the benefit of excluding these costs to assess profit is perspective.

The EBITDA metric is also said to provide a credible snapshot of the cash position of the business and its ability to service debt. Critics say this approximation for cash flow is unreliable. That’s because the EBITDA metric ignores any changes to working capital (i.e. monthly or yearly movement related to payables, receivables and stock), which can create a big cash-drain, especially for a rapidly growing business. They further argue that the lack of precision over the formula itself makes it prone to fudge.

What do the experts think about this?

Several experts feel that the EBITDA metric ignores so many expenses that it's more realistic to call it: 'profits before bad stuff'. Warren Buffett, one of the most respected financial analysts in the world, and his colleagues say this metric is junk except in language best described as ‘agricultural’. These experts argue that the premise of ignoring so many categories of costs, which a business must ultimately pay, is untenable. This makes critics wonder why EBITDA is so important?

Perhaps the answer lies with the type of businesses that rely on EBITDA in their financial statements. It is little surprise that this is a popular tool with some publicly listed technology companies, which are often eager to look more profitable (or at least reduce the size of their losses) than would be the case if they used a more conventional measure.

While there is a role for exotic metrics that isolate specific costs to assess profit, it's wise to stay savvy of terminology that businesses may use to reframe reality.

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