Why You Should Know What EBITDA Means and How to Use It

As a small business owner, you may have been asked to calculate what is referred to as an EBITDA accounting report. The Term EBITDA is an acronym that stands for Earnings before Interest, Taxes, Depreciation, and Amortization. EBITDA is used as a measure to analyze and compare the profitability of similar businesses and industries without the effect of accounting and financing activities.

While EBITDA is widely used by investment professionals and lending institutions, it’s also a powerful tool for business owners to track and monitor profitability, the operating health of their business, and their company’s financial performance.

The good news is that most online small business accounting software will perform an EBITDA calculation for you.

Examining the Elements of EBITDA

So far we have talked about the importance of eliminating financial figures associated with management decisions in EBITDA. Let’s now examine why eliminating these figures is critical.

Interest on financing can significantly reduce the gross profit of a company but does not indicate the vitality of a company’s operations.

Let’s say Company A and Company B are two identical companies in the same business. Company A has no debt and $1 million in gross revenue. Company B on the other hand has financed their entire operation at $1 million, and because of bad credit of the owner has a high-interest rate of 20%. But Company B has $1.25 million in gross revenue. All other things being equal, Company A would have a higher gross profit than Company B. But Company B would have a higher EBITDA.

So we see that based on discretionary management decisions, a company’s true potential or commercial viability can be altered or distorted, either intentionally or unintentionally. EBITDA aims to eliminate those distortions.

Several key groups look very carefully at a company’s EBITDA number including investors, banks or other lending institutions, and acquiring companies. Investors and acquiring companies may use the number to assess the performance of the company against their peer group. They may also use EBITDA figure to make non-related industry comparisons to help guide their investment decisions.

Lenders will generally look at EBITDA to assess management efficiency as well as the operational viability of a company. Since EBITDA limits the amount of “financial engineering” a company can do, it has become the top measure used to analyze the operational health of companies.

As a business owner, the only way to improve your EBITDA is to drive revenue and grow your business. However, that is not to say that accounting strategies or financing are negative. It’s not. The overwhelming majority of companies use some type of financing and implement tax and accounting strategies to improve their bottom line. These activities are productive and necessary to take advantage of tax rules and available financing.

EBITDA Margin

The EBITDA margin is a calculation that can be used by a business owner as a running score on the operating profitability of the company as a percentage of its total revenue. Once again, it is important to remember that EBITDA margin is the truest measure of a company’s health and vibrancy of just the business operations since it eliminates finance and accounting activities and focuses solely on your business activities.

The formula for calculating EBITDA Margin is as follows:

EBITDA margin = (earnings before interest and tax + depreciation + amortization) / total revenue

Some caveats to remember; although the EBITDA margin is a good indicator of a company’s financial health, it has a few drawbacks. EBITDA is not regulated by generally accepted accounting principles (GAAP), so it is not normally calculated by companies that report their financial statements under GAAP.

Why The Need to Eliminate Non-Cash, Non Operational Elements?

Eliminating accounting and finance decisions from a company’s financial records allows for the truest assessment of profitability by focusing on net income. Since finance and accounting measures can be subjective, they can distort the profitability outlook of a company.

Within the “ITDA” elements of the measure (interest, taxes, depreciation, and amortization) there is a lot of room for financial engineering that can significantly alter the appearance of the financial health of a company. Executives and business owners can use these accounting tools to create specific results that are not reflective of the core business operations.

Use the Biz2Credit EBITDA Calculator

To understand EBITDA fully we should take note that this is a measure that aims to eliminate the effects of management decisions like financing (cost of capital) and tax strategies implemented by the company. Since different companies and different industries have varied financing and accounting structures, EBITDA works to equalize or level these differences and conditionally create a “level playing field”.

Comparing EBITDA to Gross Profit

EBITDA is often confused with gross profit. EBITDA differs from gross profit because gross profit is calculated by taking the difference between Gross Revenue and subtracting the cost of goods sold (COGS). COGS will include labor, taxes, etc. (nonoperational expenses). COGS includes items affected by management decisions. To get to your EBITDA figure you would take Gross Profit and subtract the nonoperating expenses from that number.

For example, states such as Delaware have a more favorable corporate tax structure than New York. The same company operating in these two states would have different results when calculating gross profit because of tax effects. However, comparing the companies using EBITDA should be the same. Similarly, companies operating in different countries would have different national tax rates.