Everything You Wanted to Know About EBITDA Explained by an Investor

During my 10 years in finance, I have done financial analyses for hundreds of companies, and none of those studies could have been done without EBITDA. EBITDA is a universal indicator in business, like heart rate or blood pressure in medicine.

Today we will learn how to measure a company’s “heart rate” and interpret it, and compare EBITDA to other business metrics and find out how investors and entrepreneurs make decisions based on EBITDA.

Meanwhile, if you have any questions, you can use our accounting services online and we will help you out.

What is EBITDA?

Earnings before interest, tax, depreciation and amortisation (EBITDA) is a way to measure how well a company operates. EBITDA allows one to evaluate a company’s performance as well as the efficiency of its management by taking the accounting and financial situation out of the equation.

EBITDA is commonly used by analysts to define the cost of the company.

How is EBITDA calculated?

Formula 1. EBITDA can be presented as a sum of:

• the firm's operating profit
• the expenses spent as non-cash transactions (recorded in the income statement, not involving actual cash transactions) such as depreciation (reduction in value) and amortization

Formula 2. Subtract all the expenses from the net income except for those related to interest, taxes, depreciation, and amortization.

The formula for EBITDA is:

EBITDA = EBIT + Depreciation + Amortisation

EBIT stands for the operating income earned by a company. It is what you get after you subtract the expenses (except for interest, taxes, depreciation, and amortisation) from the net income.

EBITDA is usually calculated using the company’s income statement which is a historical record of the business’s trading over a specific period (normally one year).

Let’s calculate EBITDA for a London startup called IDS ChatMaster LTD that creates Chatbots.

The Sales Revenue line of their income statement shows how much money the company got over the last year – £500,000.

To calculate EBITDA, we find the items that contain EBIT (£372,000), Depreciation & Amortisation (£30,000) and then use the formula above:

EBITDA = £372,000 + £30,000 = £402,000

Why is EBITDA important?

This indicator is similar to cash flow and shows the amount of cash that the company received in the reporting period and may be used in the future.

Based on EBITDA, financial analysts can:

• determine whether the company will be able to reinvest money to expand its business and deal with its debts;
• compare similar companies on the market. The comparison becomes easier because their sizes, debts and taxes are not important anymore;
• calculate if the company has the most important feature of any business: a positive cash flow.

EBITDA is one of the core indicators for investors. When they see a high EBITDA in the report, they understand that the company can generate income and that they can get a share of it.

EBITDA in companies’ reporting will look especially alluring if there are high capital costs, as depreciation increases EBITDA. Using this indicator allows a business to hide some costs and look stronger and more attractive to investors.

Financial reporting standards do not regulate the EBITDA calculation algorithm, so the onus is on the business to decide what to include in the calculation and what to omit. There is also the possibility that a company may choose to include different items in its calculation for different periods of time, such as quarters or a year.

Understanding EBITDA

Does EBITDA include salaries?

Typically, EBITDA includes owner salaries and business bonuses.

Family-owned businesses often pay owners and family members higher salaries or bonuses than other company executives or compensate them for ownership using these benefits. So, by using this trick, business owners can make EBITDA higher.

Is a business healthy? Debt/EBITDA shows it.

Some industries need more capital than others; and that’s why a company's Debt/EBITDA ratio can be compared to the same indicator for other companies in the same sector of the economy.

In some industries, a debt/EBITDA of 10-15 can be completely normal, while in other sectors of the economy, a ratio of 3-5 might be more common.

Is a higher or lower EBITDA better?

The short answer here is “the higher, the better” and here is why: a low EBITDA indicates that a business has profitability problems as well as certain issues with its cash flow. On the other hand, a high EBITDA value means that the business’s earnings are stable.

Can EBITDA be negative?

EBITDA in the area above zero (it’s warm) means that the business is operating quite well: products are selling at a price higher than they cost to produce. In contrast, if EBITDA is below zero (it’s cold), that means the business is having some operational difficulties or that it is not being effectively managed.

How can I improve my EBITDA?

Obviously, as EBITDA is higher than the reported net income, it is often used by businesses as an accounting trick to “window dress” their profitability. It also allows the founders to show the real potential of the company to grow as well as its ability to attract customers.

There is a right way to improve this multiplicator. Here are some tips that business owners can easily use:

• Increase Sales Revenue because this is the figure that expenses are subtracted from to get EBITDA
• Increase Amortisation because it is a part of EBITDA
• Increase Depreciation because it is a part of EBITDA as well
• Don’t be aware of increasing interest expenses and taxes because they are both parts of EBITDA too.

On the other hand, make some changes in the rest of the expenses:

• Decrease the Cost of Goods that have been sold
• Decrease Rent
• Decrease Salaries
• Decrease Utilities

This is advisable because all these expenses are subtracted from the Sales Revenue to get EBITDA.

Imagine that Daniel, a respectable financial consultant, has a customer, Great Oak Furniture LTD, that wants to grow rapidly in the next 3 years. Let’s see how Daniel can help them improve their EBITDA by FY2022.

As we mentioned above, EBITDA is not included in the income statement, but let us include it for now so that we have the whole picture.

Daniel’s recommendations for Great Oak Furniture LTD are:

• take out a loan (a loan will increase the interest which is part of EBITDA );
• buy a shop and a storage space that will help the company sell more and cut rent;
• buy bigger batches of goods for lower prices (it’s obvious but it works; especially when the company owns a shop and a storage);
• buy software and hardware in order to reduce salaries;
• use compensation schemes based on the company’s stock to increase non-cash bonuses that are included in EBITDA.

To see if this advice works, let’s do some time travelling and also visit two parallel universes. In one universe, Great Oak Furniture followed Daniel’s advice. In the second one, they did not. Let’s compare the two income statements we would get while travelling around.

Great Oak Furniture LTD

1. Even though the company didn’t follow Daniel’s recommendations, it still continued growing. But it rented the storage space instead of buying it, so the Rent and Utilities part of the budget remained high, and the EBITDA does not look great. In addition, they clearly need to attract investors so as to be able to buy bigger batches of goods.
2. Having followed all of Daniel’s recommendations, the company grew very fast and showed excellent financial results. Net Income and especially EBITDA grew more than 4 times in 3 years.

What is a good EV/EBITDA ratio?

EBITDA measures a company’s overall financial performance (outcome + income; how it is progressing and improving), while EV (equivalent variation) presents the cost of the business itself.

In June 2018, the average EV/EBITDA for the company M&S was 7.4.

As a general guideline, an EV/EBITDA value below 10 is seen as healthy and above average by analysts and investors.

EBITDA vs. Other Indicators

Is EBITDA the bottom line?

Despite its widespread use, EBITDA is not generally accepted by accounting principles. Thus, it is not the bottom line in the income statement.

However, there are a lot of cases when companies report EBITDA at the owner's or management’s wish.

Is EBITDA the same as Gross Profit?

EBITDA and Gross Profit are two different things.

To find the company’s Gross Profit, one needs to subtract the Cost of Goods which have been sold from the Total Sales. Note that, quite obviously, Gross Profit is only relevant for companies that do sell goods.

As we know, EBITDA is a financial indicator that shows Earnings Before Interest, Taxes, Depreciation, and Amortization.

Let’s take a look at E-bikes LTD income statement and calculate its EBITDA and Gross Profit.

EBITDA = 172,000 + 30,000 = £202,000

Gross Profit = 800,000 – 500,000 = £300,000

As we see, the difference between EBITDA and Gross Profit is £98,000. In other words, these two are certainly different things.

What is the difference between EBIT and EBITDA?

EBIT is the amount of operating income earned by a company, and EBITDA is seen as the cash flow earned by its operations. EBIT is used to calculate EBITDA:

EBITDA = EBIT + Depreciation + Amortisation

How is EBITDA used in investment decisions?

How is EBITDA connected to a company’s value?

Basically, investors and analysts think the value of a company is 4 to 10 times more than its EBITDA.

However, shrewd buyers will push for a lower price by taking into account the company’s average results over the last few years as a base value.

If a business is in a high-growing area of the market, buyers will expect to get a significant purchase bonus. Their offer for part of the company could be 4–10 times that of the EBITDA results for the last few years. 6 times EBITDA is basically a normal multiple to strike a deal.

To ensure the highest valuation of the company, founders and owners should enhance their company's financial performance from the beginning to the present, or at least for the last three years. Firstly, they have to focus on preparing excellent financial statements.

What is the EBITDA Multiple?

It is a ratio for traders and investors. The EBITDA multiple helps to compare a company’s Enterprise Value to its EBITDA. This financial indicator is commonly used to find the value of an enterprise and compare it to the cost of other businesses in the same sector of the economy.

A company’s EBITDA multiple offers a simple way to understand the differences in capital structure, taxes, and assets which are already fixed as well as to assess how efficient the operations are in various companies.

How to calculate the EBITDA Multiple? Choose the period of time that you are interested in. Then divide EV (Enterprise Value) by EBITDA for that period.

EBITDA Multiple = EV/EBITDA

EV (Enterprise Value) = (Market capitalization + Value of debt + Minority interest + Preferred shares) – (Cash and Cash equivalents)

EBITDA = Earnings before Tax + Interest + Depreciation + Amortization.

*The data was taken from www.stock-analysis-on.net

What is the EBITDA margin?

The EBITDA margin measures the company’s profit before Interest, Taxes and Depreciation as a percentage of its Total Revenue. This margin shows a company's efficiency and is used to compare the enterprise’s real performance to others in the related industry.

The formula for determining it is quite simple:

EBITDA margin = EBITDA divided by Total Revenue (or Sales Revenue) * 100%.

Here are income statements of two similar London companies that create chatbots. Mr Hammer is an investor from Texas. He wants to invest money in an IT company based in London and is choosing between IDS ChatMaster and ChatLabs. Anyone can notice that the Net Incomes are the same. So how can Mr Hammer choose a more profitable business? Let’s work out the EBITDA margin and help him out.

IDS ChatMaster LTD/ChatLabs LTD

EBITDA margin (IDS ChatMaster) = (372,000+30000)/500000*100% = 80.4%

EBITDA margin (ChatLabs) = (372,000+1000)/500000*100% = 74.6%

An investor choosing the company as an investment will prefer the one which has a higher EBITDA margin. Three years after he invests, there may not be any interest expenses and amortisation because amortisation is restricted by time. Having done away with amortisation, the CEO could make a decision to pay off the company’s debt, so the company would get rid of the interest expenses, too. Hence, IDS ChatMaster would have a higher net income and cost more money, which is exactly what any investor wants.

What is an average EBITDA margin?

An average EBITDA margin is usually in the range from 10% to 50% depending on the industry.

Businesses that used to get many investments to stay in work conditions normally have a higher EBITDA margin.

Free EBITDA margin calculator

Check out a EBITDA margin calculator (Google Sheets) that we prepared for you.

FAQ

Is EBITDA the same as Revenue?

No. Both terms are Income Statement numbers. Revenue is the top line on the Income Statement. I's the money from sales. EBITDA's meaning is different. It is what's left from Revenue after expenses have been subtracted.

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