When you’re evaluating your company’s financial health, EBITDA is a key metric. Through it, you gain a clearer picture of operational performance than you would through revenues or profits alone. It strips away the non-operational expenses and delivers a deeper insight into profits for both business owners and investors. By answering what is EBITDA and how to calculate it, our goal is to help you make the most data-informed decisions, most notably as they relate to mergers and acquisitions (M&A).
What is EBITDA and Why it Matters
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s a way to measure profit by excluding those expenses related to financing and accounting decisions. When you eliminate these variables, you can better see if operations are running efficiently.
For more about the importance of getting a professional business valuation, check out our guide.
How EBITDA Impacts Business Valuation
While certainly not the only metric used to determine the value of a business, EBITDA has some strengths. First, it helps potential buyers and investors assess current earnings vs. earning potential by focusing only on the profits produced by operations. By excluding things like interest, taxes, depreciation, and amortization, you begin to see what cash flow actually looks like. You can use this to compare companies across industries as well as various tax or capital structures.
When you’re getting ready to sell your company or acquire a new one, you’ll feel more confident at the negotiating table when you know a company’s EBITDA.
How Do You Calculate EBITDA?
You may be surprised how straightforward this process is. We can break it into five basic steps:
- Begin by taking your net income (found on the income statement).
- Add interest expense, which is related to the company’s financing.
- Include income taxes paid during the period.
- Add depreciation, which reflects the wear and tear of physical assets.
- Finally, include amortization, which accounts for the gradual write-off of intangible assets like patents.
So, when answering how do you calculate EBITDA, we can sum this up in a formula:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
While it may look straightforward, it’s important to work with experts who can do more than the math. CPAs specializing in business valuation know how to spot potential opportunities, risks, and concerns within these numbers. They can help you better understand your EBITDA—particularly what it doesn’t show.
What is Excluded in an EBITDA Valuation?
What is EBITDA? It’s highly useful. It’s a must-know metric for business health. But EBITDA doesn’t capture everything you need to consider what a company is worth. You do need to look at what’s excluded separately to understand business potential today and into the future.
EBITDA excludes:
- Interest: Reflects the company’s financing decisions and how well they utilize capital to grow the bottom line.
- Taxes: Brings to light the effectiveness of tax strategies and what kind of tax environment this company exists within.
- Depreciation & Amortization: Informs you about the wear and tear on tangible non-cash assets like equipment, servers, and machinery, plus the aging of intangible assets that someone acquiring the company may soon be unable to claim or use.
There is also the possibility that these reflect decisions made in the past that have since been learned from or improved upon in current business strategies or changes in focus. A closer look can help you identify what these numbers actually mean for the value of a company.
Excluding these indeed creates a clearer picture. However, not looking more closely at them can be an equally detrimental mistake during an M&A valuation process.
EBITDA vs Net Income
Net income represents the company’s total profit after accounting for all expenses. These include interest, taxes, depreciation, and amortization. EBITDA, on the other hand, strips out these factors to focus on the company’s core earnings from its operations. One could argue that net income shows the bottom line of the business and is, therefore, most important. However, EBITDA is often used in valuation because it isolates operational efficiency and profitability—which is a better predictor of current financial health and growth potential.
For instance, two companies with similar EBITDA values may have very different net incomes due to differences in interest or tax obligations, making EBITDA useful for comparing companies across industries.
EBITDA Adjustments for:
While EBITDA seems simple, it’s often not the finished figure. Instead, you’ll often adjust EBITDA, excluding certain non-recurring or extraordinary expenses to home in on true operational efficiency. However, it’s important to be careful here and ensure you have a sound reason for excluding it to avoid inflating your numbers. For example, based on a company’s risks, an extraordinary expense could be a fairly frequent (recurring) expense. Adjusting it out completely could be misleading, so professional discretion is necessary.
Unusual Expenses
These might include a recent legal settlement, inventory write-offs, or a big one-time marketing push. When you adjust for these, you can ensure that EBITDA actually reflects normal operating expenses.
Extraordinary Expenses
Expenses outside of the normal course of business operations can skew numbers. These could include damages from natural disasters or an unexpected economic event.
Non-recurring Expenses
You don’t expect these expenses to happen again. They could include restructuring, relocating, or a major equipment purchase.
Need Expert Business Valuation? Contact DHJJ Today!
Whether evaluating your company’s health or considering the potential of one you want to buy, EBITDA is incredibly important. Knowing it can drive more data-informed decisions. But it’s important to work with a professional who can make the proper adjustments while understanding what this metric doesn’t tell you about a business. The business valuation experts at DHJJ can guide you through the process, ensure accuracy, and help you understand what drives your company’s value. For expert assistance with your business valuation, contact us today.
