Should Your Business Use EBITDA As a Financial Tool?

EBITDA, or earnings before interest, taxes, depreciation, and amortization, can be a useful indicator of a business’s profitability potential unobscured by current capital assets and debt. However, EBITDA is not always an accurate reflection of a company’s actual financial health.

With the guidance of an experienced certified public accountant (CPA), who can practice the art of interpretation based on the science of finance, EBITDA can serve as an indicator of business performance without the noise of capital expenses.

After reading this article, you should have a better understanding of:

• How EBITDA is calculated
• Why interest, taxes, depreciation, and amortization are excluded
• The pros and cons of EBITDA
• When it might be appropriate to use EBITDA

Key Takeaways

EBITDA can be a valuable indicator in certain circumstances, including as

• Part of the valuation of a business’s core performance
• A metric of potential growth
• A baseline for comparing performance against other companies and industries

However, without proper guidance, EBITDA can be misused or misleading because:

It is a non-GAAP (Generally Accepted Accounting Principles) measurement

• Accounting practices vary across businesses
• It ignores certain business costs and financial burdens

How Is EBITDA Calculated?

Earnings before interest, taxes, depreciation, and amortization is used as an alternative measure of a company’s profitability and can be calculated using either of the following formulas:

• EBITDA = Net Income (NI) + Taxes + Depreciation (D) + Amortization (A)
• EBITDA = Operating Profit + Depreciation Expense (DE) + Amortization Expense (AE)

Though EBITDA is not a GAAP-mandated component of a company’s financial reports, a CPA can easily calculate this figure from a company’s many financial statements, including income statements, cash flow statements, and notes to operating profit.

What Does EBITDA Tell You?

Net income indicates the net profitability of a company after expenses, operating costs, and taxes have been subtracted from total revenue. In other words, net income reflects actual financial performance after business costs are deducted.

Although net income seems like a more concrete and reliable metric of business performance, it fails to consider the impact of potential future growth on decreasing liabilities, especially in fledgling companies with heavy front-end costs.

This is where EBITDA might be a useful metric for lenders, investors, or business owners who need to get a feel for the strength of their business model.

Here’s what the EBITDA calculation excludes, or adds back into net income, and why:

• Interest. Although interest may reflect a company’s creditworthiness or financial prudence, interest does not necessarily influence a business’s performance
• Taxes. Taxes are tied solely to location and are dictated by the federal, state, and municipal tax codes of a particular address, not by company decisions
• Depreciation. Depreciation of capital assets affects some businesses more than others. For instance, a transportation company with a fleet of vehicles will have much higher depreciation values than a publishing company that owns primarily intellectual, or intangible, assets
• Amortization. Amortization simply spreads the cost of a debt over time and can be used as an indicator of the financial decisions of management rather than as a reflection of performance

In summary, EBITDA excludes financial variables not directly tied to the performance, profitability, and operations of a business.

The Pros and Cons of EBITDA

Using EBITDA in business performance evaluations has many benefits. EBITDA can:

• Act as a more reliable picture of corporate profitability, as it shows earnings before accounting manipulations and financial deductions
• Allow for fairer comparisons across industries and companies with different capital structures
• Reveal growth obscured by large debts and expensive assets common for many startups
• Reveal a company’s potential for long-term profitability
• Help determine whether a company is underutilizing its ability to borrow when compared to similar businesses
• Be used to reflect year-over-year performance
• Can reveal whether a business in need of financial restructuring has the cash flow to divert to debt in the short term

Businesses should also use EBITDA with caution, as it has some drawbacks, including:

• It is not part of the generally accepted accounting principles (GAAP) set forth by the Financial Accounting Standards Board (FASB)
• The variables, such as depreciation and net earnings, are subject to different accounting practices across businesses
• EBITDA assumes sales and operations are the only factors driving profitability and ignores the burden of a company’s assets and debts
• EBITDA does not reflect a company’s ability to fund ongoing operations and invest in growth with present product and service sales
• It can be used by companies to obscure lackluster or even negative net income numbers

As with any accounting formula used to determine the financial stability of a company, EBITDA can be useful or misleading depending on the context.

When Should You Use EBITDA?

Here are some circumstances where EBITDA may help in your business evaluations:

• When you need a baseline to determine if your company is performing above or below the industry average
• When your business is looking for an investor or lender who must determine if your company has the cash flow to pay off long-term debts and expensive assets
• When you must decide if your company can carry the burden of loan interest during a financial restructuring
• When you are determining if your business or another business represents an attractive leverage buyout (LBO)
• When you are considering the profitability of another business in light of a merger or acquisition

Note that you should always use EBITDA in conjunction with other financial indicators to gain a complete perspective on the financial well-being of your company.

How a Certified Public Accountant Can Help You Make Sense of EBITDA

Because EBITDA can vary wildly from one business to the next according to industry, size, and performance, a CPA can not only calculate your EBITDA but also help you determine whether your score is high or low within the context of your industry or market.

Though EBITDA can reveal a business’s profitability potential, it can also make your company look like its performing better than it actually is. It is not wise to make financial decisions based on EBITDA alone.

EBITDA is merely one piece of a complex financial puzzle. A certified public accountant can help you make the best financial decisions by using a variety of metrics for your specific type of business and provide context for these measurements for a more accurate portrayal of your overall business performance.

As a small business owner, having a seasoned CPA in your corner can help you refocus your energy into growing your business and supporting your employees.

Give Our Bookkeeping Team a call today to schedule a complimentary phone consultation to discuss how your business can benefit from our services. We can help you make sound business decisions, avoid costly mistakes, and save you time.