What is EBITDA?
If you’re an entrepreneur or business owner, you may have heard the term ‘EBITDA’ before, but do you know the meaning of EBITDA? Either pronounced ‘eh-bit-dah’ or ‘ee-bit-dah’, the word is an acronym for the phrase, ‘Earnings Before Interest, Taxes, Depreciation and Amortization’. EBITDA is a financial metric that shows a company’s profitability by focusing on its core operations, excluding costs related to financing, taxes, and non-cash expenses like depreciation and amortization. Essentially, EBITDA gives a clearer picture of a company’s operating performance, without the impact of financial and accounting decisions that often fluctuate.
EBITDA is sometimes used to determine whether a business can support a potential loan, line of credit, or mortgage they may be looking to take on. It allows lenders and potential investors to understand profitability clearly and removes many variables that can make it hard to compare “apples to apples”. It’s important that business owners understand the EBITDA formula and how it is calculated because it could be the difference between securing a business loan or missing out on key growth opportunities.
How do we calculate EBITDA?
As we now know, EBIDTA is “earnings before interest, taxes, depreciation, and amortization.” To calculate EBITDA, we have to add those items back to earnings (also known as net income).
The EBIDTA formula is EBITDA = Net Income (Earnings) + Interest + Taxes + Depreciation + Amortization
Or if you have operating income, it can also be calculated as:
EBITDA = Operating Income (EBIT) + Depreciation + Amortization
Let’s have a look at the components that make up EBITDA.
Earnings (Net Income)
Earnings, also known as Net Income is found in the business’s financial statements at the bottom of the Income Statement for corporations, or schedule of Business Activities for sole proprietors. They can also be often labeled as Net Profit/Loss or Net Operating Income. This is the summary of all sources of revenue minus all eligible expenses. This includes cash and non-cash expenses, and while Net Income may be a metric of profitability, it may not fully represent the actual cash available in the business as it includes paper only expenses for tax purposes and existing financing costs.
Interest
Depending on how a business is capitalized, for example how its assets are structured, there may be financing already in place from how they bought those assets. If so, any interest paid on the debts for those assets is an eligible expense for tax purposes in calculating profitability. In this case, the interest was paid along with principal payments to reduce the debt that was taken on when the asset was bought. Upon adding back the interest will allow your Commercial & Agricultural Account Manager to compare a given business’s performance to others, regardless of how the business is financed.
Taxes
Business income taxes are the T in EBITDA. Adding taxes removes the variability in comparing the performance of different businesses due to the differences in taxes that could be required. Depending on the region, type of business, and other unique factors, taxes can vary between similar businesses, so adding the taxes payable for that year allows for a more apples-to-apples comparison of the business to others.
Depreciation
Depreciation is a paper expense for tax purposes that allows a business to write off the costs of a fixed asset over its useful life span or according to tax regulations. Since depreciation doesn’t involve cash flow, they are added back to EBITDA to provide a clearer picture of a business’s ability to repay debts. For example, a small business might depreciate equipment like machinery or vehicles, spreading the cost over several years.
Amortization
Very similar to depreciation, amortization is also a paper expense for tax purposes and is a write-down for intangible or non-fixed assets. For example, this could include goodwill paid, a first franchise fee, or patent rights. Although it helps for tax calculations, amortizations don’t involve actual cash flows and are added back to EBITDA to reflect the cash that is available for debt repayment.
So why use EBITDA and is it important for business owners and managers?
As a small business owner looking to borrow money, EBITDA may be one of the metrics used to evaluate past performance, as well as to set an expectation for your future performance over the time that you may be carrying that debt.
Most financial institutions have a debt service covenant ratio (DSCR) that will look at the ratio of EBITDA to external payments and other significant debts the business has to pay. Depending on the industry or type of business, there will be an expectation for a minimum proven DSCR. For example, this could be 1.10:1 or 1.20:1. As part of the evaluation on whether to grant you the loan, most financial institutions may also require that you maintain that level of performance over the time that you are paying back the loan.
For small businesses understanding EBITDA is valuable for understanding your potential borrowing abilities. By knowing your EBITDA, you can estimate a potential loan or line of credit that may be available to you and incorporate this into your plans to grow your business.
If you’re still unsure or want to dig deeper, you can meet with one of our Commercial & Agricultural Account Managers to better understand what EBITDA is and the lending available to you to help take your small business forward.
Book an appointment today to get started.