EBITDA: What is it and why is it important?

Revolut Contributor

 · 06/09/2020  · 06/09/2020

Finance professionals often reference EBITDA when discussing company valuation and overall success of a business. There is a lot of jargon in accountancy and business, so what is EBITDA, how do you calculate it, and why is it important?

What is EBITDA?

EBITDA (pronounced EE-BIT-DAH) is an acronym and stands for Earnings Before interest, tax, depreciation and amortisation. It is a measure of profits, as it starts with your revenue and subtracts several ‘costs’ (such as cost of sales), to get to a final figure. This is done in a company’s profit and loss (P&L) financial statement, sometimes called an income statement.

The rationale behind EBITDA is that interest and tax are not necessarily related to core business operations, and depreciation and amortisation are a result of specific accounting treatments, therefore these aspects are stripped out to allow for a more consistent comparison.

How do you calculate EBITDA?

Ebitda formula:

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

By adding interest, taxes, depreciation and amortisation back to net income, you will get EBITDA. All of these elements can be found on your P&L statement. Higher EBITDA suggests greater profits are being made. A lower EBITDA suggests that operating costs are high, compared to revenue. So EBITDA is a helpful outlier as to what’s happening in your business.

Another way that EBITDA is used is in calculating your EBITDA margin. You do this by taking your EBITDA and dividing by your total revenue.

An EBITDA margin gives you insight into the efficiency with which a company is converting revenue into profits. The higher the margin, the more financially stable the company is, and the lesser the investment risk.

Why is EBITDA important?

EBITDA is important as it is an indicator of company performance. It acts as a proxy for cash flow and lets banks and investors assess how much debt a company can take on its balance sheet. As a result, EBITDA gives investors an indication as to a company’s ability to not only generate cash, but to also service its debt. These are two important considerations for an investment case.

By stripping out more subjective accounting entries, it allows investors to compare companies like-for-like on a more consistent basis, without needing to navigate through differing accounting standards and accompanying depreciation and amortisation schedules to the financial statements.

The Problem with EBITDA

A word of caution with EBITDA - although it is often used for valuation purposes, it does not include all the costs of a business. As a result it’s been criticised for not being an appropriate metric for assessing a business.

A good example of this is plant, property, and equipment (PP&E) expenditure. Capital intensive businesses can rack up a significant PP&E expense which results in Net Income being low, whilst EBITDA could suggest an extremely profitable business. It’s recommended that you look at the entirety of a company’s financial statements to get a comprehensive overview into the health of the company, rather than relying on a single metric, EBITDA or otherwise.

As a result of these criticisms, and the likelihood of investors being misled by the metric, EBITDA is not regulated as part of the UK’s Generally Accepted Accounting Practice (UK GAAP), although they do appear on P&L statements.

Despite the criticism, EBITDA is still a worthwhile metric to keep track of, as it is still used by investment analysts and other stakeholders.

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About the author

Matt is the Head of Operations (EMEA) for Fathom, looking after sales, support, account management and partnerships. Prior to becoming Fathom’s second EMEA employee, Matt was Head of Customer Experience at a scaling SaaS Plc, and he has consulted to clients ranging from sole traders to FTSE100 constituents. Matt is originally from a legal background and has experience in litigation, M&A deals and negotiating international commercial contracts.