EBITDA is a commonly used acronym in business accounting, and means Earnings Before Interest, Tax, Depreciation, and Amortisation. It helps accountants and other finance experts evaluate business profitability and performance as well as providing information to investors and being an aid for business valuation in a sale.
The metric does have its critics who claim that it can be misleading, but EBITDA is widely used in the finance world and can offer a deeper insight into a company’s operational performance than would otherwise be possible.
How does EBITDA work?
Essentially, EBITDA is a measurement of a business’ net income, with the elements making up the metric being found in the profit and loss account and balance sheet. In this respect it’s a relatively straightforward calculation to carry out.
Knowing how to read the results and understand their implications, however, is paramount. Business expenses not necessarily related to core profitability – in other words, interest, tax, depreciation, and amortisation – are excluded, presenting a potentially clearer long-term view of profitability.
When the results are used in comparison with other businesses of a similar nature, or against competitors within the same industry, the results can provide a valuable insight into how the business is performing on an operational level. In simple terms, a higher EBITDA margin when compared with a competitor is a positive outcome.
The reasoning behind EBITDA
The idea behind EBITDA is to remove the non-operating expenses and specific non-cash expenses that are particular to each organisation:
- Interest is an expense incurred following a financing decision
- The rate of tax paid is decided by the government
- Depreciation and amortisation both derive from accounting decisions within a company
In other words, decisions made externally or because a particular path is being followed that’s unique to a business, aren’t allowed to influence the result.