EBITDA - definition, how to calculate it, and pros and cons

As a (small) business owner, keeping an eye on your company's financial performance is one of the most challenging, yet important success factors. Most (small) business owners have enough on their plate as it is - creating a business plan for their new business venture, building a team, attracting first customers,...Having an efficient tool for analyzing your business's financial health can therefore be a lifesaver. This is why we've compiled this short guide to EBITDA. EBITDA allows you to not only evaluate the financial viability of a business but also compare the performance of your company against other (small) businesses with different capital structures or tax rates.

EBITDA - explained

The term 'EBITDA' is short for earnings before interest, taxes, depreciation, and amortization. It is a formula for a business's financial standing. Compared to a similar formula, EBIT (earnings before interest and tax), EBITDA is more conclusive as it removes the subjective factors that business owners have control over, such as debt financing. To understand EBITDA as a method, it is helpful to look at the individual parts of the acronym:

1. Earnings describe your company's net income/ profits.
2. Interest describes any expenses paid against any capital borrowed.
3. Taxes describes any movies paid in taxes (such as corporation tax).
4. Depreciation describes to what extent your assets have declined in value throughout their useful life.
5. Amortization describes any expenses associated with intangible assets over a specific period.

Calculating EBITDA for your business

There is a formula to calculate EBITDA: EBITDA = Net profit + Interest + Taxes + Depreciation + Amortization

For example, if your company has a net income of GPB 220,000, pays around GPB 40,000 in taxes, has interest expenses of GPB 20,000 and depreciation costs of GPB 40,000, this is how the EBITDA formula would work for you: EBITDA = GPB 220,000 + GPB 40,000 + GPB 20,000 + GPB 40,000.

EBITDA - advantages for (small) business owners

Providing you with a clear understanding of your company’s value, EBITDA can be an easy tool for (younger) business owners to understand their company's financial health. By removing any arbitrary factors like taxes and depreciation, it gives you a better idea of your own business value based solely on the strength of your business operations. This also allows you to compare your company's performance against a range of other companies. EBITDA allows you to approach your company’s financial health based solely on ongoing operations. It is a great tool for identifying your company’s potential profitability.

Downsides of the EBITDA calculation

EBITDA does provide an incomplete picture of your business's financial health. Not considering the quality of earnings, the cost of assets or the cash required to fund working capital can mean that it might look like your business has more money at its disposal than it does to pay back interest. It is advisable to use EBITDA in combination with other financial metrics when assessing your business’s value. Also, EBITDA does not consider intangibles (non-physical assets such as patents, trademarks, and brand recognition), which can also distort the picture of your company's finances.