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EBITDA Primer

Step-by-Step Guide to Understanding Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)

Last Updated March 2, 2024

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EBITDA Primer

In This Article
  • EBITDA, shorthand for “Earnings Before Interest, Taxes, Depreciation, and Amortization,” is the normalized, pre-tax operating cash flow generated by the core business activities of a company.
  • EBITDA measures a company’s operational performance since only the pre-tax cash flow generated by its core business activities is factored in.
  • The formula to calculate EBITDA adjusts operating income (EBIT) for non-cash items, such as the add-back of depreciation and amortization (D&A), and non-recurring items.
  • EBITDA is a non-GAAP measure, yet the most widely used profit metric in finance because the profit metric is unaffected by discretionary management decisions.

How to Calculate EBITDA

EBITDA stands for “Earnings Before Interest, Taxes, Depreciation, and Amortization” and reflects the operating profits generated by a company’s core business activities, expressed on a normalized basis.

EBITDA is a non-GAAP financial measure that deliberately excludes non-cash items, such as depreciation and amortization (D&A).

EBITDA measures the normalized operational performance of a business in the particular context of its capacity to generate consistent, recurring operating cash flow from its core operating activities.

The widespread use of EBITDA is attributable to the fact that the profit metric is independent of discretionary capital structure decisions and is unaffected by the tax rate, which is jurisdiction-dependent.

The step-by-step process to calculate EBITDA is as follows:

  • Step 1 → Calculate Operating Income (EBIT)
  • Step 2 → Add Back Non-Cash Expenses (D&A) to EBIT
  • Step 3 Adjust EBITDA for Non-Recurring Items (Extraordinary, One-Time Items)

EBITDA Formula

The top-down method to calculate EBITDA starts with operating profit (EBIT) from the income statement and adds back D&A from the cash flow statement (CFS).

The formula for calculating EBITDA starts with operating income (EBIT) and adjusts for non-cash items, like depreciation and amortization (D&A).

EBITDA = EBIT + Depreciation + Amortization

Where:

  • EBIT = Gross Profit – Operating Expenses (Opex)

On the income statement, the non-cash D&A expense is seldom broken out as a separate line item, apart from COGS and operating expenses (SG&A).

Therefore, one practical tip is to retrieve the D&A expense from the cash flow statement (CFS) to ensure accuracy.

On the other hand, the bottom-up method to calculate EBITDA begins with net income (the “bottom line”) and adds back taxes and interest expense to arrive at EBIT.

From operating income (EBIT), non-cash items like D&A are added back to arrive at EBITDA.

EBITDA = Net Income + Taxes + Interest Expense + Depreciation + Amortization

EBIT vs. EBITDA: What is the Difference?

EBITDA and EBIT are each pre-tax, capital-structure-neutral profit metrics with numerous commonalities.

  • EBITDA “Earnings Before Interest, Taxes, Depreciation and Amortization”
  • EBIT “Earnings Before Interest and Taxes”

The operating expenses incurred by a company, excluding non-cash items (D&A), are subtracted from revenue to calculate EBITDA.

On the other hand, the operating expenses incurred, including non-cash items (D&A), are subtracted from revenue to compute operating income (EBIT).

EBIT is an accrual-accounting-based GAAP profit metric, whereas EBITDA is a non-GAAP, hybrid measure of profitability.

The exclusion of depreciation and amortization in the EBITDA formula (and inclusion in EBIT) is the differentiating factor between the two metrics, with the percentage differential between the two metrics normally contingent on industry-specific factors.

The difference between the two metrics can be marginal at times or “night and day” in other cases, such as for capital-intensive companies with significant Capex spending requirements.

Since EBITDA is a non-GAAP measure, there is no standardized, consistent set of rules dictating the specific items that belong in the formula.

Non-GAAP measures like EBITDA are not permitted to be reported on a company’s financial statements filed with the Securities and Exchange Committee (SEC).

However, equity analysts and investors in the capital markets still pay considerable attention to non-GAAP measures in practice.

In fact, certain companies prioritize their EBITDA in management presentations, press releases, and even on earnings calls, based on the notion that non-GAAP metrics reflect their recent operating performance more accurately.

What is a Good EBITDA?

The EBITDA profit metric, by itself as a standalone metric, does not offer much practical insight into a company’s recent operating performance.

For the sake of comparability, the EBITDA metric must be divided by revenue in the corresponding period to arrive at the EBITDA margin, which is a standardized measure of profitability widely used across a broad range of industries.

EBITDA Margin (%) = EBITDA ÷ Revenue

The EBITDA margin answers the following question: “For each dollar of revenue generated, what percentage of it trickles down to EBITDA?”

The EBITDA margin is expressed as a percentage and measures a company’s operational efficiency at producing sustainable profits.

  • Historical Benchmark Once converted into percentage form, a company’s EBITDA margin can be compared to historical periods to analyze the recent trajectory of its margin profile (i.e., upward or downward trend).
  • Comparative Analysis The company’s EBITDA margin can also be used to grasp its relative standing with regard to the industry benchmark, which is set by its comparable industry peers.

There is no “good” EBITDA value per se without adequate context, such as the specific industry in which the company operates, the market size of the industry (i.e., potential revenue opportunity), and the company’s current placement in its overall life cycle, at the very least.

Generally speaking, an EBITDA margin above 10% is viewed as “good,” while an EBITDA margin that exceeds 20% is perceived as “great.”

To perform comps analysis, the reliance on the EBITDA margin is the recommended approach, practically abided by the entire finance industry.

Learn More Profit Margins by Sector (Source: Aswath Damodaran, NYU Stern)

How to Find Depreciation and Amortization (D&A)?

The cash flow statement (CFS) reconciles net income – the GAAP-based accounting profit of a company – for non-cash items and the change in net working capital (NWC) to track the real movement of cash in a given period.

The recognition of the D&A expense on the income statement is to abide by the accrual accounting reporting guidelines (U.S. GAAP) established by the Financial Accounting Standards Board (FASB).

  • Depreciation The depreciation expense is embedded within the cost of goods sold (COGS) or operating expenses (SG&A) section on the income statement. The recognition of depreciation reduces the carrying value of a company’s fixed assets (PP&E) over its useful life.
  • Amortization The amortization expense is virtually identical to the concept of depreciation. The distinction is that amortization is the incremental reduction in the carrying value of intangible assets.

Normalized operating expenses refer to a company’s recurring operating costs, like SG&A and R&D, while excluding non-cash expenses. Hence, the depreciation and amortization expense (D&A) is treated as a non-cash add-back on the cash flow statement (CFS) since no actual outflow of cash has occurred.

Likewise, D&A is added back to operating income (EBIT) based on the same intuition used to calculate EBITDA.

What are the Pros and Cons of EBITDA in Finance?

EBITDA is frequently used across all fields of corporate finance because of the ease of computing the metric (i.e.,” back of the envelope”), despite the negative criticism supporting the notion that EBITDA is a flawed measure of profitability.

  • Widespread Use → The prevalence of EBITDA is particularly common in corporate valuation and mergers and acquisitions (M&A), where the metric is frequently part of the offer price (i.e., purchase multiple).
  • Capital Structure Neutral → Since EBITDA removes the impact of one-time, extraordinary items and is considered a capital-structure neutral metric, comparisons among different companies are easier, i.e., closer to being “apples-to-apples.” The prevalence of EBITDA in valuation multiples is tied to the unlevered aspect of the metric, wherein the effects of financing and taxes are excluded. Irrespective of the capital structure, i.e., the reliance on debt or equity to fund day-to-day operations and purchases.
  • Non-Cash Items The EBITDA metric is adjusted to remove the effects of non-cash items, such as depreciation and amortization (D&A). In effect, the operating metric is not distorted by non-cash items that can be substantial for certain companies, particularly those operating in capital-intensive sectors (e.g., manufacturing, industrials, and telecom).
  • Non-Recurring Items → Often, non-recurring items (or one-time events) such as inventory impairment and PP&E impairment lead to write-downs or write-offs for bookkeeping purposes, which affects a company’s GAAP-based financials. Considering such extraordinary events are non-recurring, removing their effects is rational for forecasting and peer comparisons (i.e., “scrubbed”).

However, despite its widespread use, EBITDA receives criticism for portraying an inaccurate and potentially misleading representation of a company’s cash flow profile (and profitability).

The common sources of criticism supporting the notion that EBITDA is a flawed measure of cash flow are as follows:

  • Capital Expenditure (Capex) The primary source of criticism surrounding EBITDA is the neglect of Capex. For most companies, Capex is a major recurring cash outflow captured on the cash flow statement, but the full expenditure does not directly appear on the income statement. Instead, Capex is allocated across the useful life assumption of the fixed asset via depreciation because the monetary benefits are anticipated to continue for more than one year.
  • Change in Net Working Capital (NWC) The change in net working capital (NWC) is the increase or decrease in a company’s operational current assets and liabilities. The change in NWC can significantly impact free cash flow (FCF), but EBITDA neglects the cash necessary to fund working capital needs.
  • Non-GAAP Measure Since EBITDA is a non-GAAP metric, the lack of standardization and absence of consistency on the items to include (or exclude) present management with more discretion on the adjustments to apply.

EBITDA Calculator

We’ll now move on to a modeling exercise, which you can access by filling out the form below.

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1. Income Statement Assumptions

Suppose a company generated $100 million in revenue for its latest fiscal year, 2021.

The operating costs incurred by the company were $25 million in COGS, $20 million in SG&A, and $10 million in R&D.

By subtracting COGS from revenue, we can calculate our company’s gross profit.

  • Revenue = $100 million
  • Cost of Goods Sold (COGS) = ($25 million)
  • Gross Profit = $100 million – $25 million = $75 million

The next profit metric to calculate is operating income (EBIT), which equals gross profit minus operating expenses, i.e., the SG&A and R&D expenses.

  • Selling, General and Administrative (SG&A) = ($20 million)
  • Research and Development (R&D) = ($10 million)
  • Operating Income (EBIT) = $75 million – $20 million – $10 million = $45 million

2. GAAP to Non-GAAP Reconciliation

The next section from the operating income line is the non-operating items section, where the only line item recorded is $5 million in interest expense.

If interest expense is deducted from EBIT, we are left with earnings before taxes (EBT), otherwise known as pre-tax income.

  • Interest Expense, net = ($5 million)
  • Pre-Tax Income (EBT) = $45 million – $5 million = $40 million

Only one step is left before we reach our company’s net income, which is calculated by subtracting taxes from pre-tax income (EBT).

The tax rate is assumed to be 20%, which we’ll multiply by our pre-tax income (EBT), which comes out to $8 million in taxes.

After subtracting the $8 million tax expense from our EBT, we can determine our company’s net income is $32 million.

  • Taxes = ($8 million)
  • Net Income = $40 million – $8 million = $32 million
Income Statement (U.S. GAAP) 2021A
Revenue $100 million
Less: COGS (25 million)
Gross Profit $75 million
Less: R&D (20 million)
Less: SG&A (10 million)
EBIT $45 million
Less: Interest, net (5 million)
EBT $40 million
Less: Taxes (8 million)
Net Income $32 million

However, before calculating EBITDA starting from either revenue (“top-down”) or net income (“bottom-up”) we are still missing one critical assumption: the depreciation and amortization (D&A) expense.

The D&A expense is embedded within the income statement’s COGS and operating expenses (and rarely separately recognized).

For illustrative purposes, we’ll assume our company recognized $5 million in depreciation and amortization (D&A) on the cash flow statement (CFS).

  • Depreciation and Amortization (D&A) = $5 million

3. EBITDA Calculation Example (Top-Down)

Our next section comprises two parts, where we’ll calculate the EBITDA of our hypothetical company using the top-down and then the bottom-up method.

Under the top-down method, we’ll start by linking to EBIT from our income statement and adding back the $5 million in D&A, which equals $50 million in EBITDA.

  • EBITDA = $45 million + $5 million = $50 million

By dividing our company’s EBITDA by revenue, the EBITDA margin is 50%.

  • EBITDA Margin (%) = $50 million ÷ $100 million = 50.0%

4. EBITDA Calculation Example (Bottom-Up)

In contrast, the bottom-up method to calculate EBITDA starts with net income (or accounting profits) from the income statement.

The net income, or “net profit” metric, is inclusive of all operating and non-operating costs.

To calculate EBITDA from net income, we’ll add back taxes, interest expense, and D&A to arrive at an implied EBITDA of $50 million (and an EBITDA margin of 50%), which confirms our prior calculation is, in fact, correct.

  • EBITDA = $32 million + $8 million + $5 million + $5 million = $50 million
  • EBITDA Margin (%) = $50 million ÷ $100 million = 50.0%

EBITDA Calculator

What are the Full-Form EBITDA Components?

The following table explains the conceptual meaning and full-form EBITDA components in detail:

Full-Form EBITDA Description
Earnings
  • The “Earnings” component refers to a company’s operating income (EBIT) in a specified period.
  • EBIT is computed by subtracting the company’s operating costs (e.g., COGS, SG&A, R&D) from its net revenue in the corresponding period.
Interest
  • The “Interest” component comprises two parts, normally consolidated on a “net” basis.
  • Interest expense is the periodic payments owed to lenders as part of the financing arrangement over the borrowing term, i.e., the cost of debt (“cash outflow”).
  • Interest income is the earning brought in from investing cash in fixed-income securities, government bonds, marketable securities, and more (“cash inflow”).
Taxes
  • The “Taxes” paid are a mandatory obligation attributable to all public and private companies, but the EBITDA metric deliberately ignores the tax expense.
  • The rationale for neglecting taxes is intuitively the same as the treatment of interest, where non-operating items are excluded.
  • For instance, the tax rate at which the dollar amount of owed taxes is determined can differ based on jurisdiction.
  • Company-specific factors can also impact the income tax provision, such as net operating losses (NOLs), deferred taxes, and tax credits.
Depreciation
  • The “Depreciation” component reduces the value of fixed assets (PP&E) across its useful life assumption, which is the estimated number of years in which the fixed asset is expected to continue providing economic benefits.
  • The annual depreciation is recorded as an expense on the income statement but treated as an add-back on the cash flow statement (CFS) because there was no real movement of cash.
  • The depreciation expense is the allocation of the initial cash outlay associated with the capital expenditure (Capex) – the purchase of the fixed asset (PP&E) – over its useful life to effectively “smoothen” the recognition of the expenditure on the income statement and abide by the matching principle in accounting.
Amortization
  • The “Amortization” component is conceptually identical to depreciation, with the only distinction being that amortization incrementally reduces the value of intangible assets, such as patents and copyrights, rather than tangible assets like machinery.
  • The depreciation and amortization (D&A) expense represents a non-cash item recorded on the income statement to abide by U.S. GAAP accounting standards.
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