Do you ever think about selling your business?
Or buying one?
Then you definitely need to know about EBITDA.
You can also use it to compare your business against your competitors in your industry.
And, as ever, you can use it to see your own improvement in managing your business.
Be aware that it’s a marmite metric: some love it, some loathe it. Warren Buffet is well known for disliking EBITDA – at least, the way it manifests practically.
It’s also not used by IFRS, the International Financial Reporting Standards, or US GAAP, which are sets of accounting rules that determine how transactions must be reported. (These are what help you compare one company to another at all.)
Before you can decide to use it and pay attention to it or not, you first need to know what it is! Let’s crack on.
What is EBITDA?
EBITDA stands for:
Earnings
Before
Interest,
Tax,
Depreciation, and
Amortisation
It’s a metric used to evaluate a company’s operating performance.
It can be seen as a loose proxy for cash flow.
It’s part of a family of metrics:
EBIT:
Earnings
Before
Interest and
Tax
EBT:
Earnings
Before
Tax
In this post, we’ll focus only on EBITDA.
How do you find EBITDA?
There are a few different formulas floating around, but they all lead to the same thing. It’s just going to be easier with one vs another formula based on what’s on the financial statements in front of you.
So
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortisation
and
EBITDA = Operating Profit + Depreciation + Amortisation
and
EBITDA = Revenue – Cost of Goods Sold – Operating Expenses + Depreciation + Amortisation
All of these figures should be on your profit & loss statement (also called an income statement).
If you’re looking at a competitor’s P&L, it may be collapsed such that depreciation and amortisation are added in with Operating Expenses or some similar heading. In that case, look at their balance sheet to find their depreciation and amortisation.
Bonus: How do you find EBITDA margin?
The EBITDA margin is:
EBITDA Revenue
So, it’s a percentage. Percentages are really useful when the absolute numbers are very different.
If you’re comparing a 6-figure company with an 8-figure one, the EBITDAs will be vastly different. In order to compare the operating performance, use the margin.
What is your EBITDA?
Now, go grab your most recent financial statements and calculate your figures. I’ll wait. 😊
What does EBITDA tell us?
As I mentioned above, it’s a metric used to evaluate a company’s operating performance.
It provides a clearer understanding of operating profitability and general cash flow, to allow for comparisons of profitability between two businesses.
Why are we removing Interest, Taxes, Depreciation, and Amortisation?
Let’s look at each in turn.
Depreciation & Amortisation
These are non-cash expenses: no cash actually changes hands.
If you’re not really clear on what these are, I wrote a short primer on depreciation and amortisation. The even shorter version is that they’re a way of spreading the cost in your books of big-ticket items that should last several years.
Because no cash changes hands for D&A, it feels like a truer reflection of how the business is managed to ignore this. It also gets a number closer to your cash on hand figure.
Besides, if you’re trying to judge management, D&A isn’t really something the management can affect easily. Capitalisation policies are created when those big-ticket items are first acquired, which may well have been day 1, and generally shouldn’t change later.
Taxes
Taxes, again, are something the day-to-day management team can’t affect much. They’re ignored for this metric.
Interest
This is the interest you pay on money you’ve borrowed to set up or run your business. Usually, you’ve borrowed to buy capital – land, buildings, machines, etc.
EBITDA is focused on cash, and largely ignores capital. So it’s logical to exclude this, too.
Again, it’s not something you can really control on the day-to-day level, either.
It’s also aiming to level the playing field and allow better comparisons between different business models. Some must take on a lot of debt (and pay lots of interest) to get started; others don’t.
How can you use your EBITDA?
EBITDA is one way to value a company to sell/buy
Usually, it is multiplied by either an industry multiplier (it’s different for each industry) or an enterprise value (EV), to arrive at a value for the business.
If you want to sell your company, work to raise your EBITDA.
There are many other valuation techniques to calculate the market value of your company; do read up on them if you’re considering this.
EBITDA is a way to compare your performance against your competitors
As long as they’re in your industry, because EBITDA varies widely by industry.
This is a good way to strip back some of the things you can’t control for a more even comparison.
I gave the example of Acme Ltd and Coyote Ltd in part 3 of this series, and how their different capitalisation policies made such a dramatic impact on their Operating Profit, despite everything else being the same.
You get to sidestep that kind of issue by using EBITDA.
What should you know when comparing EBITDAs?
Comparing different things
As always, consistency is key.
This is one of the fundamental issues that Warren Buffet has with EBITDA: in practice, companies often change the items included in their EBITDA from one quarter or year to the next.
When you change what goes into it, you can’t compare it!
Comparing different things: an example
Imagine you have an allotment.
The first year, you decide to grow as many vegetables as you can. You sow every square inch with potatoes, carrots, lettuce, broccoli, radishes, cauliflower, rhubarb, spring onions, courgettes, marrows, and more.
Come autumn, you harvest your vegetables. You bring home many kilograms of vegetables. You’ve grown enough, and preserved them, so that you don’t have to buy any veggies from the shop for 4 months. Fantastic result!
This year, however, life has changed dramatically.
Someone you love has received a diagnosis. You don’t know how much time you have left with them. This year, you decide the most important thing is time spent with them.
You transform your allotment. Since you live in a flat, it seems like the best place to create an outdoor space to sit and relax, feeling closer to nature and your loved one. You sow some fruits and veggies, but mostly, you focus on making the allotment a nice place to sit. You make it beautiful, plant flowers, and spend countless hours over the summer just enjoying being together and closer to nature.
This year, you harvest much less. You bake a few courgette cakes, make one batch of jam, and have a few super-fresh salads.
On the surface, it looks like your allotment was much less profitable this year.
But that’s only if you’re counting the same thing.
And you’re not.
Last year, you were counting the veggies. This year, you’re counting the priceless memories you made.
Anytime you change what you’re counting, you really can’t compare the result.
Don’t rely on EBITDA alone
“Does management think the tooth fairy pays for capital expenditures?” – Warren Buffet
The truth is, you must look at more than one metric if you’re trying to judge a business – whether that’s a business you want to buy or sell, or simply want to manage it better.
It’s only one piece of the puzzle.
Don’t rely on EBITDA alone: an example
Suppose you were considering buying a business. You’re closely eyeing two.
Both are spirit manufacturers, and both produce fine products (you have sampled them extensively for research, of course). Their operations are quite similar, in broad strokes. Their EBITDAs are quite similar.
One is just 3 years old; the other is 40 years old.
If you looked only at EBITDA, you wouldn’t know that the older firm has a whole heap of equipment that needs to be replaced soon. Indeed, it is still using all the same large machinery that it started with, 40 years ago, some of it stuck together with binder twine and hope.
The newer firm could do with purchasing a couple of machines it currently lacks, which will increase production and save time, but the big bulk of its machines are practically new.
If you buy the older firm, you’ll need to invest a lot of money, quite quickly, into a whole host of new machines, just to keep the operation afloat.
If you buy the newer firm, you’ll want to invest a much smaller amount of money, on a timetable that you have much more control over, to improve operations rather than just to keep the doors open.
This is one example of why you should never rely on EBITDA alone.
EBITDA varies greatly from one industry to another
It’s really useful for comparing within an industry. But business model variations are too great between industries to make this a useful metric there.
EBITDA is not the same thing as cash flow
It’s an indicator metric.
If it’s your own business, be sure your team is preparing you a cash flow forecast regularly. You need that complete picture.
As mentioned above, EBITDA leaves out capital expenditure, but you do actually have to spend that money. You’ll need to replace your machines, vehicles, displays, equipment, hardware, etc, as it all wears out.
It also leaves out interest and tax – and you must make those payments, too.
Conclusion
If you’ve ever looked at your net profit figure your accountant sent you, and wondered why it’s so wildly different from your bank account, EBITDA can help you with that.
It’s a closer approximation to cash flow – though it still ignores your capital expenditure (so, the cash you’ve spent buying equipment, vehicles, etc).
For some, it provides a much clearer picture of how profitable the business is.
It makes it easier to compare different businesses, so you can get a good handle on your profitability vs your competitors’.
For others, it hides too much to be valuable.
After all, you do actually still have to pay for capital expenditures, interest, and tax. And you do need to replace your machines, etc, eventually (which is what depreciation is trying to prepare you for).
Is it useful to you? Weigh it up and decide. Should it be on your dashboard? Perhaps check back through the past 10 or 12 quarters or years to see how it’s fluctuated, and then weigh that against the rest of those financial statements and your memories (or, better yet, your notes to yourself about how each quarter or year went).
Now that you know what it is, and some of the pros and cons for using it, you can be the judge.
Hi, I’m Sara-Jayne Slocombe of Amethyst Raccoon. I help your small business thrive using the power of your numbers, empowering you so that you have the confidence and knowledge to run your business profitably and achieve the goals you’re after.
I am a UK-based Business Insights Consultant, which means I look at your data and turn it into information and insights. I separate the noise from the signal and translate it all into actions that you can actually take in your business.
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