Owning a business means understanding your company’s value. To calculate the value of your company, you can use a formula called EBITDA. But, what is EBITDA? What taxes are included in EBITDA? Are payroll taxes included in EBITDA? Grab your pen and paper while we answer these questions and look at what all goes into calculating your business’s EBITDA.
What is EBITDA?
First, what does EBITDA stand for, and what is it? EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Let’s take a look at what each of those means:
- Earnings: The net income or net loss (aka profit or loss) of a company
- Interest: Also called interest expense, interest is the cost an entity incurs for borrowing money
- Taxes: Mandatory contributions companies pay to the government*
- Depreciation: Reduction in the value of a physical asset over its useful life (e.g., a company car losing value after purchase)
- Amortization: Similar to depreciation, amortization shows the reduction in the value of a loan or nonphysical asset over time (e.g., paying off debt)
*Not all taxes are included in the calculation.
What does EBITDA tell you?
Now that you know what EBITDA is, take a closer look at what the formula does. EBITDA measures the overall financial performance of a company, specifically the profitability. However, the calculation does not include items such as property and equipment, so it can be misleading.
The ultimate goal of the equation is to give a more precise measurement of corporate performance without the influence of accounting or financial deductions.
On the importance of calculating EBITDA and what it tells you, Matthew Dolman, Esq. of the Sibley Dolman Gipe law firm said,
EBITDA is essentially a business’s complete overview of its financial performance. It allows the business to formulate its budget for the coming year, as well as determine how much of a profit it is making. It also determines any future staff layoffs, or whether there is room for team expansion.”
Earnings included in the calculation
Earnings = Revenue – Expenses
Some expenses will be added back into the equation, but not all. So, be sure to remove all expenses to calculate the earnings needed for EBITDA.
Interest included in the equation
Calculate the amount of interest your company pays for your business debts. Interest expenses have a neutral effect on the cost of debt in the equation and impact tax payments.
For example, if you have a $10,000 business loan with an interest rate of 2.5%, find the total amount of interest you pay on the loan. Only use the calculated interest and not the loan itself in the interest used in the EBITDA equation.
Taxes included in the formula
Business-related taxes are not part of the EBITDA equation, so you must remove them from the calculation.
Do not include the following business-related taxes in the equation:
- Payroll taxes
- Real and personal property taxes
- Use taxes
- City taxes
- Local taxes (separate from local income taxes)
- Sales taxes
Business-related taxes are expenses that come with running the business regardless of business structure. Because most businesses must pay those tax expenses, the taxes are not important to the equation.
However, do include federal and state income taxes in your equation. These income taxes are not considered business-related taxes, so you must add them to the calculation.
What is the role of depreciation and amortization in EBITDA?
Again, depreciation and amortization are very similar and reflect a reduction in the value of something. However, depreciation is the loss of value of a physical asset, while amortization is the loss of value of a nonphysical asset.
What is depreciation in EBITDA and its role in the equation? And, what is amortization in EBITDA and its role? The role of both depreciation and amortization is to show the business’s cash flow and usable gross profits.
A large depreciation or amortization can show the company has higher cash flow than net earnings indicate.
You can typically find depreciation and amortization on your cash flow statement.
Use your financial statements to find your earnings, interest, taxes, depreciation, and amortization. Once you have that information, use the following calculations to determine your EBITDA:
EBITDA = Earnings + Interest + Taxes + Depreciation + Amortization
There is another calculation you can use for calculating EBITDA, too:
EBITDA = Operating Income + Depreciation + Amortization
In the second equation, operating income is the profit after subtracting the costs of running the business (aka operating expenses). Operating income is typically calculated as:
Operating Income = Sales – Operating Expenses
The operating expenses include items such as wages and the cost of goods sold (COGS). Therefore, operating income gets calculated before removing interest and taxes. So, you only need to add in depreciation and amortization.
Let’s say your business has earnings, or net income, of $50,000. Your total interest expense is $5,000, income tax expense is $6,000, depreciation is $2,500, and amortization expense is $7,500. Take a look at how to calculate your EBITDA:
EBITDA = $50,000 + $5,000 + $$6,000 + $2,500 + $7,500
EBITDA = $71,000
Your earnings before interest, taxes, depreciation, and amortization are $71,000.
You have a second business, Company B, and you want to compare the EBITDA between both businesses. So, you decide to use the operating income to determine the EBITDA of your second business.
Company B has an operating income of $60,000, depreciation of $3,000, and amortization of $9,000. You calculate using the EBITDA formula like this:
EBITDA = $60,000 + $3,000 + $9,000
EBITDA = $72,000
Your EBITDA for Company B is $72,000.
Drawbacks of the EBITDA formula
Though both equations are similar, the results can be different. Net income may include funds operating income does not include. Consider using both formulas to get a better idea of your true EBITDA.
And, depreciation and amortization are added back to determine EBITDA. The drawback to this is that both items can distort the company’s earnings if the business has a large number of fixed assets. So, amortization or depreciation can inflate earnings.
EBITDA also does not fall under generally accepted accounting principles to measure financial performance. Therefore, calculations vary between businesses, and companies can choose to prioritize EBITDA over actual net income to distract from problems in financial statements.
What is a good EBITDA?
A good EBITDA is a higher number compared to other businesses in the same industry, regardless of size. The higher the EBITDA margin, the lower operating expenses are in relation to total revenue.
Use the EBITDA margin to calculate your percentage:
EBITDA Margin = EBITDA / Total Revenue
Using Example 1, your EBITDA is $71,000. Your total revenue, however, is $150,000.
EBITDA Margin = $71,000 / $150,000
EBITDA Margin = 47%
The EBITDA margin is 47%. A higher margin indicates higher profitability and a company operating more efficiently.
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This article has been updated from its original publication date of June 27, 2017.This is not intended as legal advice; for more information, please click here.