What Is EBITDA? Definition and Formula was originally published on Forage.
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Finance professionals can use details reported on annual financial statements to determine a company’s profitability using EBITDA. In general, EBITDA looks at how much money a company makes before expensing taxes and interest without considering the depreciation of assets.
In this guide, we’ll cover:
- EBITDA Definition
- How to Calculate EBITDA
- Drawbacks of EBITDA
- Showing You Understand EBITDA on Your Resume
- Related Skills for Finance Careers
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EBITDA Definition
EBITDA is a measure of profitability like revenue or net income. Using EBITDA removes the variables of depreciation, amortization, and financing by adding them back into the company’s net income (or earnings). By removing these variables, the focus is shifted to the company’s ability to generate cash flows, regardless of how they choose to finance their business, how high their tax rate is, or how quickly their assets lose value.
Additionally, EBITDA can help finance professionals compare companies in states with different tax rates. The idea is that taxes are generally out of a company’s control, so theoretically, taxes do not affect a company’s actual profitability.
However, some finance professionals and companies don’t use EBITDA at all, preferring to use other profitability metrics, like profit margins and the company’s performance history.
Who Uses EBITDA?
Many careers in finance touch upon EBITDA. For example, accountants may need to calculate their client’s EBITDA for financial statements, especially income statements. Additionally, investment bankers and mergers and acquisitions (M&A) analysts may use EBITDA to compare two companies or investment options. Investors of any level also can benefit from using EBITDA when analyzing investment options.
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How to Calculate EBITDA
You can use a few different formulas to calculate a company’s EBITDA.
Formula 1
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
Formula 2
EBITDA = Operating Income + Depreciation + Amortization
Both formulas are doing the same thing: figuring out what the company’s earnings would be if taxes, interest, amortization, and depreciation were not taken into account. Formula 2 relies on a close relative of EBITDA called EBIT (earnings before interest and taxes), which is equal to a company’s operating income.
Components of EBITDA
Earnings
A company’s earnings, or net income, is how much the company makes in a given time frame, usually a quarter or year.
Interest
Interest expenses are the cost of having debt. Most forms of debt or financing come with interest on top of the principal payment (how much you need to pay monthly or annually towards the original loan).
Taxes
A company’s total taxes include local, state and federal taxes for things like income and property.
Depreciation and Amortization
Depreciation and amortization represent the gradual decrease in value of assets over time and writing off the asset’s initial cost. Typically, tangible assets, like machinery or buildings, depreciate in value, while amortization applies to intangible assets, like copyrights or patents. Essentially, an asset is discounted because it will become less valuable as it ages. Additionally, purchasing an asset offsets some of the asset’s value.
Example Calculation
Let’s imagine an auto-parts manufacturing company with the following information pulled from their 2022 annual earnings report:
- Net income: $10,000,000
- Depreciation and amortization: $3,000,000
- Taxes: $5,000,000
- Interest expense: $5,000,000
- Operating income: $20,000,000
Using the first formula for EBITDA, we have:
EBITDA = $10,000,000 (net income) + $5,000,000 (interest) + $5,000,000 (taxes) + $3,000,000 (depreciation and amortization)
So, the company’s EBITDA based on this formula would be: $23,000,000.
With the second EBITDA formula, we have:
EBITDA = $20,000,000 (operating income) + $3,000,000 (depreciation and amortization)
With this formula, we still have the same result. The company’s EBITDA is: $23,000,000.
Drawbacks of EBITDA
EBITDA has several fundamental flaws. First, it can be misleading. For example, suppose a company has excessive debt and thus is paying a lot in interest every year. In that case, EBITDA will likely make the company seem more profitable than they actually are.
Additionally, EBITDA does not account for certain expirable assets, like copyrights and patents, or assets that lose value over time, such as machines or vehicles. In fact, EBITDA ignores capital expenditures as a whole, a primary concern of Warren Buffet, CEO of Berkshire Hathaway.
For accountants, in particular, a core issue with EBITDA is that it is not a part of the U.S. generally accepted accounting principles (GAAP). This means that it isn’t standardized, and the math can differ from company to company.
It is vital to understand what EBITDA is, the limitations of this metric, and when it can be a useful tool for financial reporting.
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Showing You Understand EBITDA on Your Resume
If you have prior work or internship experience in investment banking, mergers and acquisitions, accounting, or a related finance field, there are two key places you can mention EBITDA on your resume.
The first is in your skills section. You could mention that you are skilled in calculating profitability metrics (such as EBITDA and profit margins). However, you can also use the description of your work or internship experience as a space to bring this up. For example, you could mention if you completed a comparable company analysis on two companies, using EBITDA as a key metric.
If you do not have any work or internship experience that directly utilized EBITDA but have used it outside of the professional space, your cover letter is a great space to talk about that. For example, you could discuss if you calculated EBITDA for a friend or family member’s small business or if you used EBITDA yourself when analyzing potential investment opportunities.
>>MORE: Find more ways to show off your hard skills on your resume.
Related Skills for Finance Careers
EBITDA is a skill used by a variety of finance professionals. Other essential skills for anyone interested in finance include:
- Understanding the fundamentals of technical analysis
- Knowing how companies go from private to public (through IPOs and SPACs)
- The ability to read and understand stock charts
- Having strong analytical skills
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The post What Is EBITDA? Definition and Formula appeared first on Forage.
