Finance and money are two things that everyone has to manage. Still, they have many intense concepts behind them that are hard to understand. While most people get cash flow, valuation, and a bottom line, there are still tons of things that a vast number of concepts go beyond the average person’s knowledge of money. However, learning how to understand and use these concepts can profoundly aid a person’s experience of life, business, and financial operations.
One of these concepts is EBITDA. It’s one of the most critical measures on a company’s financial statements and one of the most effective ways to determine its profitability. Business owners and investors everywhere need to learn how to understand EBITDA and use the information it provides.
Here is everything you need to know about what EBITDA means, why it’s essential, and how to practically use that knowledge in the modern business world!
What Does EBITDA Mean?
The acronym EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s an expansion on the acronym EBIT, which stands for Earnings Before Interest and Taxes. While that can be a pretty lengthy and confusing acronym for many people, it’s much easier to understand and comprehend when you break it down to its actual purpose.
Fundamentally speaking, the EBITDA formula is a measurement and metric that takes data from a business’s balance sheet and functions to measure a company’s ability to succeed financially. IT takes information from a business’s income statement and enters it into a formula to determine some aspects of the company’s financial health.
The EBITDA formula is as follows:
- EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortization
By looking at these details, a company’s EBITDA can help to show trouble spots and overall health in a company’s actual financial viability. The whole reason why people started to use EBITDA was that investors wanted to determine if a troubled company would be able to pay interest in a leveraged buyout. The EBITDA calculation gave a lot of insight into how financially capable a company would be in troubled times.
What Do the Words in EBITDA Stand For?
When understanding how EBITDA functions, it’s essential to know what the individual words inside of it mean. Here is everything you need to know about what the EBITDA means!
The interest subsection includes expenses on the business’s operating income related to interest payments on loans or to other lenders. Almost all companies have to deal with interest expenses in one form or another. As such, they are a critical part of the EBITDA calculation. The interest rate is one of the most significant contributors to this specific aspect of the EBITDA.
Tax expenses are another significant part of the overall numbers found in the EBITDA margin. This is often found in the tax rate removed before the company’s net income. Tax is often one of the most significant operating expenses for many companies and can cut into a company’s operating profit in many ways.
This aspect of the EBITDA has to do with the depreciation expense that goes along with any working capital assets a company has. It is a noncash expense that deals with the fact that company assets that enable a company’s operating performance almost always go down in value over time. While every investment has a starting point in value, it will naturally diminish due to age, usage, and being spent in a company’s core operations.
Amortization expenses are another noncash expense similar to depreciation, except it deals mainly with intangible assets and liabilities. These tools relate heavily to a company’s financial performance and slowly become written off as the initial investment into the asset gets its worth back.
What Are the Benefits of Using EBITDA?
Many benefits come with using the EBITDA calculation to understand and uncover critical information about the company you’re dealing with. Here are some of the primary benefits:
- The EBITDA removes variables and details that are unique to each business. It operates based on generally accepted accounting principles that apply to almost every company and puts everything within a highly understandable operating cash flow. This makes it easier to compare companies and understand them on the most objective terms possible.
- The EBITDA makes it easy for investors and onlookers to see how profitable the company is without looking at all the specific details. While each company may have a different basis for the cost of goods sold, capital expenditures, or enterprise value, this system makes it easy to objectively understand company functionality.
- EBITDA is also very easy to both calculate and evaluate. While other coverage ratios and formulas can be complicated and hard to understand, the EBITDA is a reasonably simple and easy to apply formula. This has given it a lot of application in the modern world of business and finance and gives it a lot of spotlight in the public details of most companies.
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A Clear Look at EBITDA | Investopedia
Ebitda Definition & Meaning | Dictionary.com
Amortization | Wex | US Law | LII / Legal Information Institute | Cornell