EBITDA (earnings before interest, taxes, depreciation and amortization) is an important financial metric that gives insight into a company’s operating profitability. By removing the impact of financing and accounting decisions, EBITDA provides a clear view of the underlying cash flow potential of the business.
Knowing how to properly calculate EBITDA is key for analysts and investors when evaluating companies. It allows comparison across companies of different sizes in the same industry. Lenders may also look at EBITDA to gauge a company’s ability to repay debt.
This comprehensive guide will walk through step-by-step how to accurately calculate EBITDA based on information from a company’s financial statements.
Understanding the Components of EBITDA
First, it helps to understand exactly what makes up EBITDA:
- Earnings: Also called operating income or operating profit on the income statement. This refers to a company’s profits purely from operations and excludes all other line items.
- Interest: Interest expense on debt that a company pays over a period. Could include bonds, loans or lines of credit. Appears on the income statement.
- Taxes: All tax expenses including federal, state and local taxes paid out of earnings. Part of net income calculation.
- Depreciation: An accounting expense that reduces earnings due to the lowering value of assets over time. Non-cash expense.
- Amortization: Similar to depreciation but for intangible assets. Also non-cash.
By removing all these other factors impacting net income, EBITDA shines a light on the profitability of daily business operations.
Step-by-Step EBITDA Calculation
Here are the key steps to calculate EBITDA from a company’s financial statements:
1. Identify Operating Income on the Income Statement
The first number needed is the company’s operating income, also called operating profit. This appears on the income statement and excludes all income and expenses not directly tied to normal business operations, like interest income, interest expense and taxes.
Operating income reflects profits purely from the business’ core offerings and services.
2. Add Back Interest Expense
The next component to tackle is interest expense paid out over the specific reporting period being analyzed. Interest expenses arise from any interest-bearing debt the company carries, like bonds issued, lines of credit from banks or long-term loans.
Add the interest expense indicated on the income statement back into the operating income number.
3. Add Back Tax Expenses
Similarly, taxes reduce net income but are not part of ongoing operations. Add back all tax expenses including federal, state, local and foreign taxes tied to the period analyzed. Tax expenses typically appear their own line item on the income statement.
4. Add Back Depreciation Expense
Depreciation represents spreading out the costs of large purchases like machinery and equipment over the useful life of the assets. Since it’s a non-cash accounting expense, depreciation gets added back into earnings for EBITDA.
Find depreciation expense for the specific reporting period on the cash flow statement or in the footnotes of the financial statements.
5. Add Back Amortization Expense
Like depreciation, amortization allocates the costs of intangible assets like patents, trademarks and copyrights over multiple years. As this too is a non-cash expense, amortization also gets added back for EBITDA calculations.
Identify the amortization figure from the income statement or cash flow statement, similar to depreciation above.
6. Subtract Any Gains
Nearly there! But be sure to subtract any gains from sales of assets or unusual profits that aren’t tied to core business operations. For instance, if the company sold company-owned real estate at a profit.
Gains might appear in the “Other Income” section of the income statement or within the footnotes.
7. Calculate EBITDA
The final EBITDA formula pulls all the numbers together:
EBITDA = Operating Income + Interest Expense + Taxes + Depreciation + Amortization – Gains
The resulting EBITDA figure provides a clear snapshot of the cash earnings potential of the business.
Comparing EBITDA Across Companies
A major benefit of EBITDA is facilitating comparisons across companies, even those with very different capital structures and sizes.
Since EBITDA removes distortions from how companies may finance themselves or the accounting methods they employ, it offers an “apples-to-apples” view of profitability.
Analysts frequently look at EBITDA margins, dividing EBITDA by total revenue. This normalized metric calculates the percentage of revenue converted into core operating profits.
Comparing a software giant like Oracle to a retail chain like Target would prove difficult using net income. But with EBITDA margins, analysts can clearly see which business converts more revenue into cash profits.
Higher margins indicate businesses with lean operations and pricing power for their products or services. It’s easy to rank competitors across an entire industry using EBITDA margins.
EBITDA Limitations
While very useful, EBITDA does have some drawbacks to consider:
- It does not account for the capital intensity of running the business. Companies may have vastly different capital expenditure needs which EBITDA ignores.
- Interest expenses and tax rates can vary significantly across companies. EBITDA overlooks the impact of debt leverage and tax management.
- It does not indicate the amount of working capital needed to operate the business. Managing inventory, accounts receivable and accounts payable burdens can differ widely.
- Since EBITDA excludes capital investments, it cannot indicate future earnings potential or growth. Two firms can have similar EBITDA today but vastly divergent prospects.
Overall EBITDA serves as an excellent supplementary metric. Analysts will often use it in conjunction with other measures like revenue growth, return on assets (ROA) and free cash flow to assess overall company and stock performance.
Conclusion
Learning how to properly calculate EBITDA opens up fantastic insight into the operating profit engine of any business. It serves as a widely used additional indicator of performance, especially valuable for comparisons across companies and industries.
While a few limitations exist, EBITDA remains enormously helpful for stripping out accounting distortions. Analysts, investors, business owners and lenders examine it closely alongside other metrics to best evaluate companies.
By mastering the key steps outlined here for accurately calculating EBITDA from financial statements, anyone can leverage this knowledge for smarter analysis and financial decision making.
Whether used for picking stocks, assessing merger targets or even managing your own small business, get ready to unleash the full potential of the flexible EBITDA metric.