EBITDA, which is short for “Earnings Before Interest, Taxes, Depreciation, and Amortization”, is a financial instrument that helps understand a business’s capability to produce cash flow for its owners. Additionally, it also acts as a judge of a company’s operating performance.
As agreed by several investors and analysts across the globe, EBITDA guides them through the many stages of corporate profitability. This metric is super useful for people looking to compare companies within the same industry. It is known to offer a simple yet comprehensive perspective on the core financial performances of different business models.
It is not the only tool, but it does provide you with an open picture of your company’s performance in the marketplace. More often than not, we can assume EBITDA as a magnifying glass that zooms in on the operational well-being of a business without factors like accounting and financial decisions.
So, without much ado, let’s get into some of the most burning questions people always wanted answers for! Read ahead and get solutions to every question you ever asked about EBITDA.
24 Burning Questions about EBITDA answered in 2024!
Here are some frequently asked questions that have been airing around for long enough. Let’s dive in and explore every little detail about EBITDA!
1. How can you explain EBITDA in simple terms?
EBITDA basically stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. In fact, this is one of the ways that helps in measuring a company’s financial performance without having to bring in financing decisions, tax environments, or accounting decisions. In other words, this is a financial metric that gives a clear view of the profitability of a company’s core operations. Moreover, EBITDA is not a metric identified under Generally Accepted Accounting Principles (GAAP).
2. How is EBITDA calculated?
There are basically two EBITDA formulas. Out of the two, one is based on net income while the other is based on operating income. These both typically arrive at the same result.
EBITDA = Net Income + Taxes + Interest Expense + D&A
EBITDA = Operating Income + D&A
Herein, D&A means “Depreciation and Amortization”.
Now, when we talk about calculation, the process looks quite different. This is where you need to take your company’s profit (usually the net income) and add back interest expense, taxes paid, depreciation, and amortization. It is similar to adding back costs that do not correspond to your regular business activities.
3. How do you interpret the EBITDA ratio?
The EBITDA ratio helps us compare a company’s performance without the impact of accounting and financial decisions. Put another way, it is a percentage that exhibits the portion of each dollar of revenue that your business turns into operating cash. Higher ratios usually reveal that the company is efficient and profitable. However, it is imperative to compare this ratio within the same industry. This is because standards can vary massively between different sectors.
4. Is a 30% EBITDA margin good?
Typically, a good and high EBITDA margin is actually relative to the industry of the organization. Let’s say, for example, a tech company which has a higher EBITDA margin can usually be anywhere around 30% to 40%. However, in other industries, such as hospitality, a good margin might be anywhere between 10% to 20%.
5. How is EBITDA different from profit?
EBITDA mainly differs from profit since it removes the impact of accounting and financing decisions. In layman’s language, profit (often referred to as net income), however, comprises these factors. EBITDA is a metric that helps to measure a company’s profitability. Profit, on the other hand, is a financial benefit a business receives as a result of revenue exceeding expenses, costs, and taxes.
6. What is a good ratio for EBITDA to revenue?
Again, there is actually no magic number that can specifically give us the full picture. A good EBITDA margin is basically relative because it largely depends on the industry the company is based. However, an EBITDA margin of 10% or higher is considered good. In fact, a higher margin can often suggest lower operating costs in relation to total revenue. In contrast, a low or below-average margin can potentially hint at red flags with cash flows and profitability.
7. Is the owner’s salary included in EBITDA?
EBITDA is basically the primary cash flow measurement that is primarily used to value mid to large-sized business models. Moreover, for your answer, it is no. EBITDA does not include the owner’s salary as an adjustment.
8. Can net income be higher than EBITDA?
Let’s skim through this formula to understand better. The formula is, “EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization”. Here, you can clearly see that the net income is mainly the starting point to evaluate the EBITDA formula. As a result, it is pretty clear that EBITDA will almost always be higher than net income.
9. Should EBITDA be higher than operating profit?
In general, EBITDA is higher than operating profit. Operating profit, which is often also called operating income, can be evaluated by deducting operating expenses (for example, rent, wages, and cost of goods sold) from the gross profit. EBITDA, on the flip side, goes a little longer by adding back interest, taxes, depreciation, and amortization to the operating profit. Now, because depreciation and amortization are non-cash expenses, they are known to minimize operating profit but are then added back into the EBITDA calculation. This is how it produces a higher result.
10. Do you add back bad debt expense to EBITDA?
In general, bad debt expense is not seen to be added back to calculate EBITDA. Nonetheless, bad debt expense is actually taken as an operating expense. Moreover, this impacts the calculation of operating profit but you cannot see it getting added back in the EBITDA evaluation. As you know, EBITDA mainly focuses on added back items which are non-operational or non-cash. This can include anything between interest, taxes, depreciation, and amortization.
11. Is EBITDA usually higher than net profit?
Yes, EBITDA is generally higher than net profit. EBITDA is basically the net income before you take out interest, tax, depreciation, and amortization expenses. Therefore, they are non-cash expenses that don’t directly affect the operating efficiency of a business. By excluding these items, EBITDA focuses on the core operational efficiency. Net profit, on the flip side, takes all expenses into consideration. This includes interest, taxes, depreciation, and amortization. Since EBITDA only takes into account operating expenses, it will generally be a larger sum than net profit.
12. Does EBITDA include gain on sale of assets?
No, EBITDA generally does not comprise the gain on the sale of assets. But, why is that, you may ask? The gains or losses on the sale of an asset comes under non-operating items. Contrary to common belief, EBITDA just solely focuses on the earnings that come from regular operational activities before interest, taxes, depreciation, and amortization. That is why, one time gains or losses are usually excluded from the asset sales.
13. Are property taxes excluded from EBITDA?
Yes! You guessed that right. Property taxes are typically excluded from the EBITDA calculation. EBITDA normally excludes for types of expenses from earnings:
- Cash expenses: Interest and taxes
- Non-cash expenses: Depreciation and amortization
This is a financial metric that helps to compare two very similar businesses or to determine the cash flow potential a company may have.
14. Are bank charges included in EBITDA?
If related to interest expenses, bank charges are excluded, too, from EBITDA. Why does this happen? Well, this is because EBITDA adds back interest expenses to the operating profit. In addition, interest generally does not include bank fees, or merchant fees.
15. Does EBITDA include interest income?
EBITDA is basically a company’s net income but, when looked closer, it excludes the impact of interest income or the expense of debt instruments, depreciation, and amortization. This financial instrument can give you a better picture of earnings from the ongoing business activities.
16. Can EBITDA be negative?
Definitely. EBITDA can be negative. Now, this can happen when a company’s operating expenses surpass its gross revenue. In simple words, a negative EBITDA reveals that the business is actually not profitable at its core operations level. This is even prior to considering expenses such as interest, taxes, depreciation, and amortization. Moreover, this is a type of circumstance that typically worries investors and analysts because it goes on to show several fundamental issues with the company’s business model or direct market conditions.
17. Can EBITDA be over 100%?
The very concept of EBITDA being higher than 100% sounds nothing but quite misleading. Usually, this financial metric is exhibited in absolute monetary values (such as, euros or dollars) rather than as a percentage. It cannot itself be over 100% since it is a percentage that is represented to help us know the earnings before specific expenses. On the other hand, EBITDA margins (that is, EBITDA divided by revenue) can be over 100%. Yet, the EBITDA margins as well range between 1% to 100%. It usually never surpasses 100%, as seen to date.
18. What is the rule of 40 with EBITDA?
The Rule of 40(no follow code), popularized by Brad Feld and Free Wilson during 2015, says that a SaaS company’s revenue growth rate added to its profit margin must be equal to or exceed 40%. Simply put, if the SaaS company is growing by 30%, its profit should be 10% or more. Additionally, this is a way to measure how successful small, fast-growing businesses are.
Here’s the Rule of 40 Formula:
Growth Rate (ARR in % YoY growth) + Profit Margin (In EBITDA as % of revenue) ≥ 40%
19. EBITDA vs. Cash flow: What is the difference?
Although cash flow primarily aids in measuring the actual inflow and outflow of cash, EBITDA concentrates on the operational profitability of a company before accounting for tax, financial, and accounting expenses. Cash flow gives an overview of the liquidity of a company. Moreover, it’s also important to know that EBITDA is widely used to analyze operational efficiency and further compare profitability without the effect of financial structure. Cash flow, on the other side, helps us understand a company’s ability to produce cash to fund its operations, pay debts, and invest.
20. Is EBITDA and gross margin the same thing?
No, EBITDA and gross margin are nowhere similar to one another. EBITDA helps us measure the profitability of a company. On the flip side, gross margin is basically the revenue portion that is left after the subtraction of the cost of goods sold (COGS).
21. What is the difference between EBITDA and adjusted EBITDA?
EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization, helps measure a company’s operating cash flow before factoring in financing, taxes, and asset related expenses. Whereas, adjusted EBITDA takes in hand the standard EBITDA and adds back or subtracts specific items which are considered non-recurring, unusual, or non-operational.
While EBITDA is primarily useful for comparing operational efficiency of businesses that are in the same industry, adjusted EBITDA represents a more normalized and proper picture of the company’s underlying profitability. If you’re wondering how to calculate it, then it’s simple. Adjusted EBITDA is just plus or minus adjustments. That means, “EBITDA = EBITDA ± Adjustments”.
Moreover, let’s have a brief look at some of the adjustments you might need to exclude in this case:
- Non-operating revenue (for example, asset appreciation)
- Legal costs or expenses
- One-time gain or sale of property
- Impairment of assets
- Forex gains or losses
- Impairment of goodwill
- Unrealized gains and losses
- Restructuring and reorganization
22. What is normalized EBITDA?
Normalized EBITDA is actually a non-GAAP financial metric that helps to analyze a company’s operating cash flow. In addition, it can be evaluated by adjusting the standard EBITDA to remove the impact of non-recurring and irregular events.
23. Why is EBITDA misleading?
Many analysts and investors use EBITDA, or earnings before interest, taxes, depreciation, and amortization, as a stand-in for a company’s operating performance. However, there has been a lot of discussion about its validity as a tool for valuation, especially from well-known investors like Warren Buffett. Some of the many reasons why it can be misleading are:
- Excludes capital expenditures
- Ignores working capital changes
- Not a GAAP measure
- Tax impact is ignored
Thus, EBITDA can act as a useful tool in evaluating a company’s operational efficiency. However, if you’re solely relying on this instrument, it can be misleading because it excludes various vital financial factors.
24. What is a better measure than EBITDA?
If we need to decide whether there is a better measurement tool than EBITDA, we have to consider a lot of factors. In other words, it depends heavily on your specific context and purpose. Here are some measures that can be better than EBITDA:
- Free cash flow
- EBIT (calculated as gross profit minus the operating costs)
- EVA (Economic Value Added)
- Net income (reports the company’s total profits, not just the operating profit)
EBITDA is a super important tool that can help us determine how well a business performs. Now, although it does come with its own limitations, EBITDA should not really be neglected. Every tool in the financial arena is equally essential to consider, regardless of its structure, definition, function, and sole purpose.
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