Introduction
An important metric to measure a business’s financial health is the EBITDA calculation. A financial analysis is important for all businesses and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is the way to get a clear view of the company’s operational performance and profitability (after removing non-operational costs). EBITDA is a common tool used by investors, financial analysts, and business owners worldwide to compare their business to others in the industry and determine the valuation.
In this article, we will cover: Importance of financial analysis, Definition of EBITDA, Formula and step-by-step calculation, EBITDA’s importance in financial analysis and limitations of EBITDA.
Why is Financial Analysis Important?
Periodical financial analysis is important for a business because it helps in understanding profitability, liquidity, and overall financial health. The financial analysis numbers help in managing the cashflow, optimize costs and assess investment viability. Businesses employ financial analysis to identify their strengths, weakness and growth opportunities and detect financial instability early to mitigate risks.
What is EBITDA?
EBITDA has gained quite an importance in recent years because of its ability to measure, analyze, and compare profitability between corporations and industries.
Earnings Before Interest, Taxes, Depreciation, and Amortization are a representation of a company’s profitability, not including the non-cash expenses, tax policies, and other accounting and financial decisions. EBITDA is used as an alternative to earnings, revenues, and income metrics of finance. The EBITDA comparison is not bound by regulatory conditions, capital investments, or tax structure.
What does EBITDA Stand for?
EBIT: Earnings before Interest and Taxes
- Interest: This is the expense incurred by the company, interest rates, loans, or third-party lenders. It varies by the company’s credit history, and location.
- EBIT = Operating revenue – operating expenses
- Taxes: These are paid to the government or state as directed by the authorities in the region, and they vary depending on the type of business and location.
Depreciation
- This Indicates Asset Value Reduction: Like the way the cost of a car reduces once’s it is out of the showroom, the value of tangible assets is a non-cash expense that indicates the reduction in the value of the asset. The depreciation is often due to external factors.
Amortization
- This measures the reduction in the value of the intangible assets of a business, such as patents, trademarks, software, goodwill, etc. It is also a non-cash expense is defined as a process that gradually writes off the initial cost of the asset.
Why is EBITDA a Preferred Measure Over other Metrics
Owners, investors, and stakeholders can use this financial analysis measure to compare two other companies even if they are in different locations. Since EBITDA does not take into account variables such as taxes, interest expenses, etc., it becomes a perfect way to determine a business’s worth and benchmark it against industry averages.
The profitability metrics of EBITDA are calculated for a set accounting period and exclude depreciation and amortization because these expenses can vary greatly between companies because of their location and impact the company’s net income. With EBITDA, the earnings from core activities are highlighted.
EBITDA Formula and Calculation for Financial Analysis
There are two simple formulas to calculate EBITDA
1. From net income
EBITDA = Net income+ Interest+ Taxes+ Depreciation+ Amortization
2. From EBIT
EBITDA = EBIT (operating income) +Depreciation + Amortization
Example Calculation
A company presents the following data over a financial year:
- Net Income: ₹ 10,00,000
- Interest Expense: ₹ 50,000
- Taxes: ₹ 50,000
- Depreciation: ₹ 80,000
- Amortization: ₹ 20,000
Using the above given formula: EBITDA: 10,00,000+50,000+50,000+80,000+20,000=12,00,000
So, the business’s EBITDA is ₹12,00,000.
This information is a must include in the company’s income statement and must be done accurately. Its miscalculation will have an impact on the business’s profitability directly.
EBITDA Calculations as a Financial Metric
EBITDA emphasizes more on the operating decisions of the company. Here are some important calculations used in financial analysis:
EBITDA Margin
This is a relation between the aggregate earnings and revenue and indicates the cash profit the firm will make in a year. Formula:
EBITDA Margin = EBITDA / Aggregate Revenue
The larger the margin, the better the growth potential looks for the business as it indicates financial efficiency.
EBITDA Coverage Ration
This important financial metric indicates financial capability. It indicates if the company is viable enough to pay off the interest-related expenses. Formula:
EBITDA Coverage Ratio = (EBITDA + Lease Payments)/ (Interest Payments + Principal Payments + Lease Payments)
The EBITDA coverage ratio of 1 or more than 1 indicates good financial condition.
Why is EBITDA Crucial for Financial Analysis?
EBITDA can be calculated directly from the income statement of the company. It is a clear and comparable figure of business performance. Here is why it is critical for financial analysis:
1. Evaluates Operational Performance and Profitability
EBITDA focuses on how well the company can generate profit from its core activities.
2. Simplifies industry comparisons
EBITDA is a universal calculation and is not affected by tax structures and regulatory bonds of regions. Using this figure, it becomes easier to fairly compare two companies that have varying capital structures without bias. This helps in identifying investment opportunities.
3. Benchmark for Valuation (Enterprise Value to EBITDA Ratio)
It becomes a key metric for investors to use the EV/EBITDA ratio for the business valuation. A low ratio indicates undervaluation and higher ratio overvaluation. The EBITDA margin is used as a comparison of different businesses in the same industry.
4. Analysis of Business’s Debt Capacity
Since EBITDA excludes the tangible and non-tangible expenses, interest expenses and the taxes, for the lenders this calculation indicates whether the company can pay the loan and the interest back.
5. Identifies Cash Flow Trends and Potential
EBITDA indicates the potential cash flow and cash-generating ability of the company. This is a useful metric for investors and stakeholders to gauge the company’s growth in terms of reinvestment, debt payments, and dividends, especially for capital-intensive businesses.
How To Ensure Accurate EBITDA Assessment
- Consider the industry context, as different industries have different EBITDA ratio benchmarks.
- Comparisons should be made between companies that have operational similarities, have a similar customer base and margins.
- Growth rate of the business indicates the future profit potential.
- Comparing EBITDA with the industry averages help determine overvaluation or undervaluation to make informed investment decisions.
Disadvantages of EBITDA
- Does not take into account the capital expenditures, which can cause the figures to be misleading as they do not indicate the business’s actual earnings.
- Since it does not reflect the cash flow changes in inventory, accounts receivable, or accounts payable, many businesses use it to hide poor financial decisions and their shortcomings.
- EBITDA does not include interest payments; it hides the financial struggle of the company, making it appear profitable even when it is not.
- Since it is not a standardized metric, there can be variations in the calculation and may not present an accurate financial picture.
Final Thoughts
Investors and lenders rely on EBITDA to determine the creditworthiness and business valuation to make informed decisions about investing and gauge if the business is the right fit for sustainable growth and profitability. It is a good metric for industry comparison and operational performance. When used along with other metrics such as net income, free cashflow, and operating cashflow, it is easy to generate a clear and full financial picture of the business.
Read Also: What is Equity and valuation In Startup Ecosystem?
