One of the best and most accurate ways to measure the overall financial performance of your small business is to calculate your earnings before interest, taxes, depreciation, and amortization, the business acronym of which is EBITDA. This is an often-misunderstood accounting metric among business owners due to its complexity. Calculating EBITDA involves many steps, and an accurate result can only be obtained with up-to-date accounting records. Knowing your EBITDA is vital to your company’s investment plans and operating decisions. So, you must understand EBITDA and learn how to calculate it and interpret the results. This Balboa Capital blog post answers the question, “what is EBITDA?” and provides you with the helpful information you need.
Overview: What is EBITDA?
As mentioned earlier, EBITDA is a unique metric that helps small business owners see how their companies are performing at any given time. It can be used to project a company’s profitability, assess its value, identify cash-flow potential (or cash-flow problems), and determine how much funding is needed to pay off short- and long-term debt. In addition, EBITDA can help entrepreneurs uncover growth opportunities. EBITDA consists of these six (6) parts:
E = Earnings
This is your company’s net income (or net loss) for the specific period (month, quarter, or year) that you are calculating your EBITDA.
B = Before
I = Interest
When calculating EBITDA, the interest your company earns and any costs related to interest (i.e., paying debt) are not subtracted from your earnings.
T = Taxes
Your earnings before taxes are included in the formula. You can find your taxes in the non-operating expenses section of your company’s income statement.
D = Depreciation
Equipment, vehicles, and technology, among other tangible assets, depreciate over time and lose their original value.
A = Amortization
If you have intangible assets such as trademarks, patents, or franchise agreements, they are added to your company’s profit.
Before calculating your company’s EBITDA, you will need to gather some financial documents and review them to ensure they are current. These include your balance sheet, cash flow statement, and income statement. If everything in these reports is accurate and up-to-date, it is time to get started. Next, you can choose one of two formulas for calculating. One formula uses net income, and the other formula uses operating income.
To calculate your company’s EBITDA using the net income formula, you must add your net income to your interest, taxes, depreciation, and amortization. To better illustrate this, let us use a boutique winery as an example. The winery’s net income for last year was $2 million. The winery owners paid $200,000 in interest and $180,000 in taxes and had $250,000 in winery equipment depreciation. Lastly, the winery had $10,000 in amortization and paid $180,000 in taxes. Here is how the winery determined its EBITDA with the net income approach:
|Winery Equipment Depreciation||$250,000|
Next, we will take a look at the winery’s EBITDA using the operating income formula. This is achieved by adding operating income to depreciation and amortization. The winery’s operating income for the year was $4.7 million, so here is the calculation:
|Winery Equipment Depreciation||$250,000|
After you finish your calculation, you might want to consider taking it one step further to determine your EBITDA margin. If you find out that your company has a high margin, this is an excellent sign. It means that your company is in good financial health and presents less risk to borrowers and potential investors. Conversely, if you have a low margin, it is time to revisit your company’s financial obligations and expenses and make improvements where needed.
Calculating the margin is straightforward. Just divide your EBITDA by your total revenue. Let us say that your EBITDA for last year was $1,000,000, and you posted $2,500,000 in annual revenue. Your EBITDA margin is 40% ($1,000,000 divided by $2,500,000). You can also look online for the average margin for companies in your industry to see how you measure up.
What is a good margin?
This is where it can be confusing, as all businesses and industries are unique. For example, companies in the healthcare sector typically have a much higher EBITDA margin than restaurants and retail shops. However, the critical thing to remember is that a high margin is not a bad thing. On the contrary, it is often a sign of higher potential growth, more significant profit margins, and improved cash flow.
EBITDA margins can range from 1% to 100%, but they are almost always less than 100%. The reason is, margin can only hit 100% if a company had no taxes, depreciation, or amortization for the period being calculated. Therefore, if your margin exceeds 100%, you must check your accounting records for errors and discrepancies and start the process over.
Last year in the U.S., the average EBITDA margin across all industries was 16.5%, so this is a good benchmark to use. In addition, there is a consensus among financial experts and analysts that margins higher than 15% are considered “good” because they indicate lower operating costs/expenses relative to total revenue.
EBITDA gives you a good idea of how your small business is performing, but it should not be the only metric that you use. It would also help to look at your cash flow, return-on-investment (ROI), year-over-year growth, operating income, and net income. Analyzing all of these metrics will provide you with a comprehensive overview of your company’s financial situation and performance.