EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s a financial metric that can be used to understand how profitable a business is, without taking into account daily operating expenses.
If you’re looking to invest in a company, apply for a business loan, or want to sell your business, the EBITDA ratio is a useful financial health check. Read our guide to understand more about what EBITDA means, and how to calculate it.
EBITDA can be a useful financial metric for you to understand profitability of your business, but it has its limitations.
As a measure, it looks at the amount of profit your business makes before interest, taxes, depreciation and amortization have been deducted. This can help investors understand how effective a business is on a management and operational level – and essentially how well it manages debt.
EBITDA can be particularly useful for startup companies as it includes expenses associated with getting the business up and running, such as equipment.
Before looking at how to calculate EBITDA, you’ll need to understand the financial terms involved.
Earnings – this is how much your company makes in profit. Our guide on how to calculate profit goes into more detail on this.
Interest – relates to the interest on any money you’ve borrowed to finance your business activities. This expense is excluded from EBITDA as companies have different capital finance structures, which can give a different picture of performance.
Depreciation – non-cash expenses related to the reduction in value of a company’s assets over time. For example, you bought equipment for your business and it cost you £20,000. You expect it to last 10 years, so the depreciation expense is £2,000 every year (i.e. £20,000 divided by 10).
Amortization – non-cash expenses related to loans (debt) or capital expenses for intangible assets (goodwill, patents, copyrights) where payments are spread out over time.
Depreciation and amortization are non-cash expenses that have to be recorded on a business’s income statement. They both show gradual non-cash expenses paid over time, and neither affect cash flow of the business.
In terms of how they differ: depreciation relates to physical assets while amortization refers to intangible assets or loans.
There are two ways you can work out EBITDA for your business.
You can find this information on your income statement, cash flow statement, and balance sheet.
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While EBITDA is a raw number, the EBITDA margin is a profitability ratio. It shows EBITDA as a percentage of revenue, so to calculate it you need to divide EBITDA by revenue.
As an example, let’s look at an annual income statement for a fictional homeware business.
|Example Income Statement||Totals (£)|
|Less: Cost of Goods Sold (COGs)||(£5,000)|
|Less: Operating Expenses||(£5,000)|
|Earnings before Interest, Tax, Depreciation and Amortisation (EBITDA)||£20,000|
|Less: Interest expense||(£2,000)|
|Profit Before Tax (PBT)||£16,000|
The EBITDA margin here is 67 per cent (£20,000 / £30,000). A higher percentage margin is usually a good indicator of profitability, but average EBITDA margins can vary vastly depending on the specific industry.
These figures are illustrative.
This metric is mainly used by financial analysts, investors or banks if you’re looking for a business loan.
That said, it can also be useful to compare competitor businesses against yours as part of a SWOT analysis of your business.
One of the advantages of EBITDA is that it can be used to compare businesses in the same industry using one standard measure.
However, it has limited use on its own as it can skew results. For example if you have a lot of high-value assets, depreciation would increase EBITDA, so this could make your company appear more profitable than if you looked at net profit.
Therefore you should use EBITDA in combination with other measures such as working capital, net income, cash flow, and net and gross profit margins.
You should also be aware that EBITDA isn’t accepted under the generally accepted accounting practice in the UK (UK GAAP), the body responsible for regulating accounting standards.
For more financial tips, read our guide on how to increase profit.
Business finance is a complex topic. Please treat this article as a guide only and get professional advice if you’re not sure about anything.
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