EBITDA stands for earnings before interest, tax, depreciation and amortisation. It can sound more confusing than it really is, but understanding what EBITDA is is actually fairly straightforward.
What is EBITDA?
It is a profitability KPI commonly used by analysts and investors. It allows them to company Businesses profitability by stripping out financing costs, accounting adjustments and tax.
Hence its acronym – Earnings Before Interest, Tax, Depreciation and Amortisation.
How to Calculate EBITDA
EBITDA is worked out using the figures included in the income statement (or profit & loss account) and is calculated as follows:
EBITDA = Profit + Interest + Tax + Depreciation + Amortisation
An Example of EBITDA
Here is the Profit & Loss account of Example Accounts Limited. Let’s suppose there is depreciation fo £2500 included within administrative expenses.
EBITDA is therefore £133,250 which is worked out as follows:
£106,750 + £24,000 + £2,500 = £133,250
What is EBITDA Used for?
By stripping out financing costs, accounting adjustments and tax we are left with a businesses operation profit. This figure can then be compared against other businesses across a wider range of industries.
EBITDA is considered an unbiased method of measuring a businesses operational profit because, for example, one business may have more financing from lenders whereas another may be funded by Directors. Naturally in this example one business will pay more in financing costs such as interest but this shouldn’t affect its operational efficiency & profitability. So by using EBITDA both these businesses can be compared in an impartially. Likewise one business which faces higher tax rates because of where it is located can be compared more fairly to another which is located one which pays cheaper tax rates since tax rates would not affect business efficiency.
The Pitfalls of EBITDA
As with any KPI, they should never be considered in isolation. EBITDA can be deceiving for example:
- If a business requires expensive fixed assets to run which need replacing every few years, stripping out depreciation to assess its operational profit will not reflect the huge cost associated with running the business;
- A business may need large amounts of cashflow to run, meaning some form of financing would be necessary so large interest charges are part of the day to day operation of the business;
- Tax rates are set by government and unavoidable (well, mostly) so is stripping it out the entirely correct thing to do?
When you run a business you will no doubt be faced with the question ‘What is your EBITDA?’. Depending on your intentions for your business, it is worth understanding what your EBITDA is but also whether it is a fair way to measure your operational efficiency in isolation depending on the industry you operate in so when you do respond you can give a more accurate overview of your profitability.