EBITDA: What It Is and Why You Need It?

There is a lot of information about how and how much the company earns in the Profit and Loss statement. These data can be used in different ways. For example, net profit helps calculate dividends. Gross profit helps compare a company’s performance in different types of activity.
EBITDA indicator was created to compare efficiency of the core activity of two different companies. EBITDA means "Earnings before interest, taxes, depreciation, and amortization". This metric shows the company performance in core activity. You cannot find this indicator in the standard accounting reports, so you have to calculate it yourself.

EBITDA is revenue less fixed and variable costs. Let’s find out more and learn how to calculate this metric. What’s hiding behind the letters of this quite familiar for financiers abbreviation?

Calculation is based on net profit (E stands for Earnings), which is further adjusted by a number of expenses. Firstly, we “return” taxes (T stands for Taxes). In other words, we start our calculations with pre-tax profit without taking into account any specifics of company taxation.

At the next step, we add interests on loans and credits (I — Interest). A company can operate entirely on its own resources or take a loan, and the structure of the capital can be different. But it doesn’t mean that EBITDA has to change.

Finally, we increase the indicator by the sum of amortization and depreciation (D and A stand for Depreciation and Amortization). For example, a company has spent several thousands of dollars on an expensive machine today. This money will be reflected in small amounts in the depreciation section of the Profit and Loss statement over several years. This is a non-cash expense in terms of profit. It exists only on paper and, in addition, depends on the company accounting policy, so it’s not always included in operating profit.

The calculation of EBITDA is not fixed by any official standards. It’s necessary to be careful when comparing performances of different companies. The subtlety is that sometimes profit could be adjusted for additional amounts. For example, the "virtual'' income from the revaluation of assets might be deducted. This should be kept in mind to compare truly comparable metrics.

EBITDA is a must for management accounting for a reason. This metric can be quite useful in different situations.

First of all, the owner of the company will need EBITDA to understand whether operations are profitable and there is enough money to pay for investment and financial expenses or not. EBITDA is the closest to operating Cash Flow of all P&L metrics. It allows us to understand how much the company earns from the core activity without counting any non-cash expenses.

When evaluating the dynamics of EBITDA, it’s important to understand that profit has to be positive and grow over time.

EBITDA is quite useful for the company comparison because it considers only core activity without taking into account:

• taxes (for example, there could be different tax policies in different countries but it doesn’t affect the company efficiency);
• non-cash expenses (companies can have different approaches to depreciation accrual);
• capital structure.

It’s better to compare companies of about the same size and from one sphere. Comparison can be made on both absolute and relative metrics (a ratio of EBITDA to revenue).

EBITDA is required to calculate several financial indicators. The most common of them is the Debt/EBITDA ratio. It shows by how many times the company’s debt exceeds its profit. In other words, how many years it will take for the company to repay its debts if it allocates the whole profit on it. If the Debt/EBITDA ratio is high, it means that the debt burden is too high.

Sometimes the owner of the company wants to evaluate it. For example, he plans to sell it or wants to analyze the dynamics of growth. One of the most common ways is to use a multiplier. It’s a relative value that helps compare companies which are different in size, but similar in type of activity. For example, we can calculate the industry average EV/EBITDA (the ratio of market value adjusted for debt to profit) and multiply it by our EBITDA. This will give you an approximate idea of how much the company is worth.

Management accounting is useful because it allows you to calculate almost anything. We’d recommend you to add EBITDA to the list of performances. You can calculate it on your own, but special services (for example, FinPlan) allow you to do it quicker. EBITDA will help to understand how efficiently the company is managed and whether there is enough money for investments and repayment of financial obligations. Moreover, it’s an easy way to compare different companies!