What is EBITDA?

Every company analyzes financial metrics and numbers to gauge the health of their businesses. While there is a plethora of methods to evaluate a firm’s financials, EBITDA (earnings before interests, taxes, depreciation, and amortization) represents one of the most commonly used metrics to indicate a company’s financial health. So, it is no surprise that startups also rely on EBITDA to measure how their core operations are working and to predict future growth and cash flow.?

What is EBITDA?

As mentioned, EBITDA is an acronym for “earnings before interests, taxes, depreciation, and amortization.”. The calculation for EBITDA was developed in the 1970s by John C. Malone, the former president and CEO of the media giant Tele-Communications Inc. The purpose of the EBITDA formula is to show a company’s earnings performance and is also used to project the long-term profitability of that business. In addition, EBITDA provides a standardized metric that can be employed to compare different corporations within the same industry. Or serves as a valuation method to assess a budding business.

Before we have a look at how EBITDA is calculated, let’s dissect and explain each component that constitutes EBITDA:

• Earnings: The money that a company retains after deducting all the business expenses and taking into account corporate taxes is called earnings, or net income. There are also operating earnings, which subtract operating expenses from revenue, and we can either use net income or operating earnings for EBITDA calculation.
• Interests: These are the costs that a business incurs when they borrow money. When a startup seeks debt funding from angel investors or venture capital firms, they have to pay interest on those loans. Interests can also represent proceeds from investment, but EBTIDA only concerns the interest expense.
• Taxes: Every entity has to pay its obligations to the government, including startups. Depending on the type of company, taxes can come in the form of corporate taxes or individual income taxes.?
• Depreciation and amortization: These are the category of expense that is only recorded on a company’s book without affecting the real cash flow. That is, tangible assets (equipment, buildings, machinery, and vehicles) lose their value over time; therefore, businesses need to estimate the value loss in dollar terms and record it as depreciation. The same concept applies to amortization, except companies keep track of the eventual expiration of intangible assets (like patents) as amortization expenses.?

How to calculate EBITDA

As the name implies, we first calculate a business’s earnings and then take out any changes that stem from interests, taxes, depreciation, and amortization, to deduce EBITDA. For example, suppose a finance service startup specialized in buy now, pay later (BNPL) service has the following information regarding its financials:

• Net income: $5 million
• Interest paid: $300,000
• Depreciation: $532,000
• Amortization: $200,000
• Taxes paid: $132,500

We add all these expenses back to the net income: Net income + interest + depreciation + amortization + taxes = $5 million + $300,000 + $532,000 + $200,000 + $132,500 = $6,164,500 = EBITDA

Why use EBITDA??

The reason why we add back all those costs to net income is that EBITDA more closely indicates the operational performance. In other words, interests reflect the cost of capital, depreciation, and amortization shows the declining value of an asset, and taxes are obligations to the government. None of them exhibit how effective a company is in generating sales and revenue.?

Going back to our BNPL startup, this industry will most likely require an arrangement of software, patents, and other intellectual properties. As a result, the company might have to record a noticeable amortization expenditure as time passes. Furthermore, since the business is still in its nascent stage, debt financing will typically demand high-interest rates because of the high risk associated with startups, leading to oversized interest expenses.?

To prevent all the above aspects from obscuring investors from the startup’s operational capabilities, the business would want to use EBITDA. The metric adds back all the costs related to the mentioned categories, providing accurate earnings potential from the company’s core operations. Internal management teams also have a clearer picture of how different factors affect profitability.

Other use cases of EBITDA

Investors, as well as corporations, compute EBITDA for various reasons. Bankers and creditors use the metric to determine a company’s debt service coverage ratio (DSCR). DSCR is a type of debt-to-income ratio, and banks rely on DSCR to assess a business’s ability to service its debts. A VC firm might use EBITDA to consider between a number of startup investments, as this valuation method delivers a standardized comparison among the businesses. Overall, EBITDA provides a fairer view of how well a business is performing, especially those that need heavy upfront investment to grow and expand, allowing an investor to appraise its long-term potential and viability.?

Drawbacks of using EBITDA

Even though businesses and investors widely use EBITDA, the formula does have some flaws that might make it unideal to deploy. First of all, a negative EBITDA means a company is having a rough time with its earnings, but a positive EBITDA does not guarantee decent financial health. Even though we add back some of the expenses to the net income, that doesn’t mean firms don’t have to pay them eventually. For example, the famous investor Warren Buffet once claimed that depreciation is a real cost that can’t be ignored, and EBITDA is not “a meaningful measure of performance.”?

Additionally, EBITDA calculation can be deceptive. This is because companies purposely use EBITDA to make their earnings seem stronger than they really are. Capital-intensive firms and startups can compute EBITDA to reasonably reflect their true revenue-generating capability. If, however, a company starts to use the metric predominantly to report its financials while historically have not used EBITDA, that might be a red flag for investors. Meaning, the business could be trying to conceal its huge expenses from outsiders.