EBITDA refers to a company’s earnings before deducting interest expenses, taxes, depreciation, and amortization. It is an acronym that stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.
As an indicator, it is used to calculate a company’s profit-making ability or its ability to generate income for its owners.
Why use EBITDA?
The advantage of using EBITDA to evaluate a company’s performance is that it is capital structure neutral. It doesn’t include factor in non-cash expenses like depreciation, which may or may not affect a company’s ability to generate income.
How to Calculate EBITDA
Simply put, EBITDA can be calculated using these formulas:
Formula #1: EBITDA = Operating Profit + Depreciation Expense + Amortization Expense
Operating profit, also known as EBIT or Earnings Before Interest and Taxes, is the amount of profit that a company generates only from its operating activities.
- Depreciation expense is the cost of the company’s tangible assets such as machine, building, and equipment allocated over the duration of its useful life.
- Finally, amortization expense is the cost of the company’s intangible assets over the duration of its useful life.
Let us take an example. Suppose this is an income statement from a clothing store.
|EBIT (Operating Profit)||18,000|
Formula #2: EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortization
In calculating EBITDA using this second formula, it is worth noting that the figures here depend on how a company interprets these metrics and how they define operational profit and operational income. In some cases, a company may interpret this metric in a way that includes all expenses and income generated, including those from core operations and other sources.
Thus, we begin calculating net profit or a company’s total earnings after expenses have been deducted, then add back Interest, Taxes, Depreciation, and Amortization.
Let us take an example. Suppose this is an income statement from the same clothing store above.
|EBIT (Operating Profit)||18,000|
EBITDA as a non-GAAP measure
GAAP stands for Generally Accepted Accounting Principles, representing a common set of standards followed when carrying out accounting-related calculations. EBITDA is considered a non-GAAP measure of a company’s operating performance because companies have a higher level of discretion than desired when calculating their EBITDA. This makes it possible for a company to manipulate figures to suit their own interests, as with some cases involving non-GAAP measures.
However, the EBITDA is not entirely irrelevant. If a company considers EBITDA’s limitations during its calculation and analysis, it would be possible to make use of this metric as one of several calculations available for the purpose. In order to understand this metric better, a company may begin with its basic calculation and study its underlying components during its analysis.
EBITDA vs Operating Income
These two metrics are slightly different from each other in a way that EBITDA takes into account a company’s profit, including interest, tax, depreciation, and amortization expenses. On the other hand, operating income shows a company’s profit after taking out its operating expenses like depreciation and amortization.
Simply put, EBITDA measures the profit potential of a company, while Operating Income is often used to ascertain how much of a company’s revenue can be converted to profit.
EBITDA vs Net Income
EBITDA and Net Income’s main difference is that EBITDA refers to a company’s earnings, taking out the interest, tax, depreciation, and amortization expenses. On the other hand, net income refers to a company’s earnings after taking into consideration all the expenses it has incurred.
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