The term EBITDA, pronounced “ee-bit-dah”, is an acronym used to describe the financial performance of a business.
It is an important metric in determining the value of a business, as it shows how profitable the company is, independent of its capital structure or tax situation. EBITDA is used essentially to determine the ‘true’ value of a company and to loosely put a number on cash flow, instead of simply analysing profits.
What does EBITDA stand for?
EBITDA is an acronym which stands for: Earnings Before Interest, Taxes, Depreciation and Amortisation.
Here is a breakdown of the acronym:
Earnings
Earnings refers to the profit that a company generates from its operations. This can be any form of income that the company generates.
Before
The ‘before’ part shows that the rest is to be excluded from the calculation.
Interest
Interest refers to the cost of borrowing money. If a company has a loan, it will have to pay interest on that loan, which is a business expense and is factored into EBITDA.
Taxes
This refers to the taxes that a company has to pay on its income.
Depreciation
Depreciation refers to the decrease in the value of assets over time. For example, if a company buys a piece of machinery for £10,000 and uses it for five years, the machine’s value may have decreased to £5,000 by the end of the five years.
Amortisation
This is similar to depreciation, but it applies to intangible assets, such as patents or trademarks.
Who invented EBITDA?
John Malone was the inventor of EBITDA and created the framework in the 1970s in order to more accurately assess the value of a business.
His business, which was initially in the consolidation of cable systems, used EBITDA to assess how effectively telecommunication companies could generate cash. This was important, as these companies were often involved in leveraged buyouts, so Malone needed to ensure that the companies could handle the debt involved in an acquisition.
EBITDA then became an industry standard, as companies needed a more effective way to assess a company’s value.
How to calculate EBITDA
EBITDA is calculated by starting with a company’s net income (which is the opposite of gross income) and adding back interest, taxes, depreciation and amortisation, which have been removed in order to calculate the net income.
As net profit has already subtracted interest, tax, depreciation and amortisation, EBITDA works to add back these metrics to measure operating performance.
To explain, calculating EBITDA follows this formula:
- EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortisation
EBITDA can be calculated in two ways:
- Starting from net income – One way to calculate EBITDA is by starting from net income, and then adding interest, tax, depreciation and amortisation back on.
- Starting from Operating Profit (EBIT) – Another way to calculate EBITDA is by starting from operating profit, the ‘EBIT’ section, and then adding depreciation and amortisation
While it might seem that these two methods are similar, each has a distinct benefit.
Starting from net income has the benefit of scrutinising the bottom line of a company. Whereas, starting with operating profit, the assessment can give a clearer view of operating performance. Each one is effectively the same, and should come to the same result, but simply gives a different structure and priority to the analysis.
An example of EBITDA
EBITDA can be tricky to understand for anyone new to business.
Here is a simplified example of EBITDA in practice:
Imagine you run a small construction company and your client pays you £10,000 for a construction project, which is your revenue.
You then spend £5,000 on materials for the project. You also pay a subcontractor £2,000 for their labour on the job. This means your total direct costs amount to £7,000.
However, your payments will likely include interest on any loans taken, taxes, and factor in any depreciation in assets (such as machinery) or amortisation. This could amount to around £2,000.
Therefore, your business might be making £1,000 from this job (£10,000 – £7,000 – £2,000 = £1,000). However, this £1,000 profit is a relatively opaque number, as it does not accurately represent how effectively your business is operating.
Therefore, to truly understand financial health, EBITDA is used to calculate the true earnings of the business.
In this case, the EBITDA would be £3,000, or 30%, which would paint a more accurate picture of your business’s true value in the market.
Why is EBITDA important when looking for business finance?
EBITDA is often used as a measure of a company’s operating cash flow because it excludes non-operating expenses such as interest, taxes, depreciation, and amortisation. This makes it a useful metric for evaluating a company’s ability to generate cash from its operations.
When seeking financing for a business, potential lenders will want to evaluate the financial health of the company.
However, it’s important to note that EBITDA is not a perfect metric, and isn’t the only metric used to evaluate a company’s financial performance.
Here are all the benefits of using EBITDA when looking for business finance.
1. EBITDA reflects operating performance
EBITDA strips out non-operational and non-cash expenses, providing a clearer view of the business’s core profitability. This makes it easier for lenders or investors to assess whether the business can generate enough earnings from operations to support debt repayments.
2. EBITDA neutralises capital structure differences
Because EBITDA excludes interest, it allows comparison between businesses with different financing structures. This is especially helpful for lenders evaluating companies across sectors or stages of growth.
3. Indicator of debt serviceability
Lenders often use EBITDA as a proxy for cash flow to calculate debt service coverage ratios (DSCR). A higher EBITDA typically means more capacity to cover interest and principal repayments.
4. Used in valuation and credit decisions
EBITDA is often used in business valuation models and credit analysis. A strong EBITDA improves your bargaining position when negotiating loan terms or valuation in equity funding.
5. Common requirement in loan covenants
Many commercial finance agreements include EBITDA-based covenants (e.g., maintaining a minimum EBITDA or leverage ratio). Strong, stable EBITDA signals lower financial risk to lenders.
6. Helps identify operational efficiency
Changes in EBITDA over time can indicate whether a company is becoming more or less efficient in its operations, useful for both internal management and external stakeholders.
Is EBITDA the same as gross profit?
EBITDA and gross profit are not the same.
EBITDA starts with operating profit and then adds back non-cash expenses, such as depreciation and amortisation.
Gross profit is simply the overall earnings of the company, not taking into account any overheads. Gross profit strictly focuses on the direct profits of the company, whereas EBITDA is designed to give a much clearer picture of the true earnings of a company.
Criticisms of EBITDA
Although EBITDA is widely used, it is not necessarily a legitimate measure of a company’s success, and is often used as an initial guideline prior to deeper analysis.
Warren Buffett has famously called EBITDA “utter nonsense”.
Here are some of the main criticisms of EBITDA:
1. Ignores key costs
EBITDA excludes interest, taxes, depreciation, and amortisation, which are real and sometimes substantial expenses. Critics argue that by removing these, EBITDA can overstate profitability and mask the true cost structure of a business.
2. Not a measure of cash flow
Although some use EBITDA as a proxy for cash flow, it does not account for changes in working capital or necessary capital expenditures, both of which affect a company’s liquidity and financial sustainability.
3. Can mislead on the debt burden
Since interest is excluded, EBITDA doesn’t reflect a company’s ability to service debt. This can be especially problematic in highly leveraged businesses, where interest costs are significant.
4. Depreciation/amortisation should not be overlooked
These are non-cash expenses, but they reflect the wearing out or obsolescence of assets. Ignoring them may paint an overly optimistic view of profitability, particularly in capital-intensive industries like manufacturing or telecoms.
5. EBITDA can be manipulated
Because EBITDA is not defined under accounting standards (e.g. IFRS or GAAP), companies can adjust the figure to make performance appear stronger. Some may use “Adjusted EBITDA,” selectively removing costs that arguably should be included.
There’s no universal rule for calculating EBITDA, so comparisons across companies can be misleading unless definitions are made transparent.
6. Overused by investors and analysts
Its popularity may lead to over-reliance in place of metrics like net income, free cash flow, or return on capital employed (ROCE) offer a more complete picture.
In many cases, free cash flow in relation to net income or return on capital employed also offers effective analysis.
Conclusion
EBITDA is a widely accepted and important financial metric, which is used to assess the effectiveness of a business.
This makes it especially useful for lenders and investors who need a benchmark in order to assess whether a business is profitable, and how capable they are at handling debt.
While EBITDA is helpful, it should be taken with a pinch of salt, and used alongside other key indicators like cash flow.
If you’re interested in getting financing for your business, but aren’t sure whether your business is eligible, then feel free to apply for a free instant quote.
You will find out within as little as 24 hours whether you will receive funding, and will have a dedicated finance specialist assigned to you.
