EBITDA Primer

In This Article

• EBITDA stands for “Earnings Before Interest, Taxes, Depreciation, and Amortization”.
• EBITDA reflects 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.
• The depreciation and amortization (D&A) expense is excluded from EBITDA and treated as a non-cash add-back because there was no real outflow of cash incurred.
• EBITDA is a non-GAAP measure, yet the most widely used profit metric in finance because the metric is unaffected by discretionary management decisions, like the capital structure.

How to Calculate EBITDA

EBITDA reflects the operating performance of a company’s core business activities, expressed on a normalized basis.

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.

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

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

Therefore, U.S. GAAP accounting standards prohibit the recognition of EBITDA on the income statement.

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)
• Step 3 ➝ Adjust 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, such as depreciation and amortization (D&A).

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 and adds back taxes and interest expense to arrive at EBIT, from which non-cash items like D&A are added back to arrive at EBITDA.

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

The formula to calculate EBITDA starts with net income — from which taxes, interest expense, depreciation, and amortization are added back.

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 costs 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 gross profit to calculate 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.

The percent differential between the two metrics (or “spread”) is contingent on industry-specific factors, like capital intensity. For instance, the variance between the two metrics can be substantial 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 are not permitted to be reported on a company’s financial statements filed with the Securities and Exchange Committee (SEC).

However, equity analysts and market participants pay considerable attention to non-GAAP measures.

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

Why is D&A an Add-Back Adjustment in EBITDA?

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.

The depreciation expense is the allocation of the initial cash outlay associated with a capital expenditure (Capex)—i.e., the purchase of a fixed asset (PP&E)—over its useful life to “smoothen” the recognition of the expenditure on the income statement and abide by the matching principle in accrual accounting.

The term “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 occurred. Likewise, the equation to solve for EBITDA adds back the non-cash D&A expense to operating income (EBIT) based upon the same logic.

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, EBITDA must be divided by revenue in the corresponding period to calculate the EBITDA margin—or EBITDA to revenue ratio—a standardized measure of profitability widely used across a broad range of industries.

The formula to calculate the EBITDA margin is the ratio between EBITDA and revenue, expressed as a percentage.

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.
• 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.

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

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

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

How to Forecast EBITDA

Forecasting EBITDA is seldom done in practice because of the implicit assumption that the underlying components of the metric are tied to revenue at a fixed percentage.

One exception is to perform a “back-of-the-envelope” analysis on a late-stage, mature company exhibiting stable operating performance and minimal growth (e.g. 3% to 5% YoY growth).

For instance, a private equity firm might forecast the EBITDA of a company as part of building a short-form LBO model to vet a potential acquisition.

The formula to forecast EBITDA is the EBITDA margin assumption multiplied by the projected revenue in the coinciding period.

The EBITDA margin assumption is normally set based on the historical margin profile of the company and recent trajectory in the trailing couple of periods, including the industry benchmark (“comps”).

But to reiterate, as it bears repeating, forecasting EBITDA is merely a quick method to determine the economic feasibility of an investment opportunity, which precedes a more granular analysis, assuming the acquisition is deemed worthwhile.

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). EBITDA is often referenced in the offer price (or the 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.
• Non-Cash Items ➝ The EBITDA metric is adjusted to remove the effects of non-cash expenses, 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 the 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 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 is not recognized on the income statement. Instead, Capex is allocated across the fixed asset’s useful life assumption via depreciation because the monetary benefits are anticipated to exceed one year (>12 months).
• 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 inconsistency on which specific items to include (or exclude) offers the management team with more discretion on the adjustments to apply.

How to Calculate FCFF from EBITDA

The free cash flow to firm (FCFF) metric, or “unlevered free cash flow”, is the residual cash flow attributable to all capital providers, including common equity shareholders, preferred stockholders, and debt lenders.

The formula to calculate the free cash flow to firm (FCFF) starts with NOPAT, and adjusts for D&A, the change in NWC, and Capex.

Therefore, to calculate free cash flow to firm (FCFF) starting from EBITDA, the first step is to deduct D&A from EBITDA to arrive at operating income (EBIT).

The next step is to tax-affect EBIT to determine NOPAT (or “EBIAT”).

Once NOPAT has been calculated, the subsequent steps are to adjust for non-cash expenses (D&A), subtract the change in net working capital (NWC), and deduct Capex, resulting in FCFF.

The “[(EBITDA – D&A) × Tax Rate]” component of the equation computes NOPAT. Therefore, the adjustments applied are identical thereafter to arrive at FCFF from EBITDA.

Conceptual Overview of EBITDA

Before we pivot into our interactive modeling exercise in Excel, the full-form components of EBITDA are each defined in the following table.

EBITDA Calculator — Excel Template

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

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. Top-Down EBITDA Calculation Example

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

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. Bottom-Up EBITDA Calculation Example

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%