# EBITDA

Guide to Understanding EBITDA

## How to Calculate EBITDA (Step-by-Step)

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

The conceptual meaning of EBITDA – stated in simple terms – is the normalized operating earnings generated from a company’s core business activities, while neglecting non-operating items, such as the effects of financing decisions and taxes.

Therefore, EBITDA measures the financial performance of a company in the particular context of its core operation’s capacity to generate consistent, recurring cash flows.

The EBITDA metric deliberately excludes non-cash expenses – namely depreciation and amortization – since the recognition of those items on the income statement is related to the accrual accounting reporting standards established under U.S. GAAP.

The depreciation and amortization expense, or “D&A”, represents a non-cash add-back on the cash flow statement (CFS).

1. Depreciation Expense → The depreciation expense is embedded within the cost of goods sold (COGS) or operating expenses (Opex) line item on the income statement. An accrual accounting convention, depreciation is a non-cash expense recognized on the income statement to reduce the carrying value of a company’s property, plant & equipment (PP&E) over its estimated useful life assumption, i.e. fixed assets with a useful life assumption in excess of twelve months, or one year.
2. Amortization Expense → The amortization expense is virtually identical to the concept of depreciation. The only distinction of amortization is that the incremental reduction is applied to the intangible assets belonging to a company across its estimated useful life, as opposed to its tangible, fixed assets.

## EBITDA Formula

Since EBITDA is a non-GAAP measure, there is no standardized, consistent set of rules dictating the specific items that belong in the formula. However, the most common formulas used to calculate the EBITDA metric are as follows.

EBITDA = Revenue Cost of Goods Sold (COGS) “Normalized” Operating Expenses
EBITDA = EBIT + Depreciation + Amortization
EBITDA = Net Income + Taxes + Interest Expense + Depreciation + Amortization

The term “normalized operating expenses” refers to a company’s operating expenses, such as selling, general and administrative (SG&A) costs and research and development (R&D), but excludes non-cash expenses like depreciation and amortization (D&A).

If the starting point is net income, i.e. the “bottom line” of the income statement, the steps to calculate EBITDA would involve adding interest, taxes, and non-cash items.

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

The widespread usage of the metric is primarily due to the metric being capital structure independent and unaffected by differences in taxes, which is jurisdiction-dependent and can be skewed by items such as net operating losses (NOLs).

## Conceptual Meaning of EBITDA

Before we delve further into the EBITDA metric and our practice exercise tutorial in Excel, ensure each component in the formula is truly understood by reviewing the following table.

Full-Form Components Description
Earnings
• The “Earnings” component refers to the operating income (EBIT) that a company generates across 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” piece is comprised of two parts: interest expense and interest income.
1. Interest Expense: The periodic interest payments owed to lenders as part of the financing arrangement over the borrowing term of the debt, i.e. the cost of debt financing (“cash outflow”)
2. Interest Income: The earnings brought in from investing cash in fixed-income securities, government bonds, marketable securities and more (“cash inflow”)
• On the income statement, the two types of interest are often consolidated on a “net” basis, but regardless, both are non-operating expenses related to discretionary decisions by management (and are thus not representative of a company’s core operating performance).
• Hence, neither interest expense nor interest income is deducted from EBITDA.
Taxes
• The “Taxes” paid is a mandatory obligation attributable to all companies, whether publicly-traded or private, but the EBITDA metric deliberately ignores the tax expense.
• Like interest, taxes are also a non-operating expense and are recorded below the operating income (EBIT) line item, meaning that the tax expense is not deducted from the calculation.
• The intuition to neglect taxes is similar to the rationale for the treatment of interest. For instance, the tax rate at which the dollar amount of owed taxes is determined can differ based on the company’s jurisdiction and various company-specific factors can impact the amount paid in a period such as net operating losses (NOLs), deferred taxes and tax credits.
Depreciation
• The “Depreciation” concept in accrual accounting reduces the value of fixed assets (PP&E) across its useful life assumption, which is defined as the estimated number of years in which the asset is expected to continue providing economic benefits.
• On the income statement, the annual depreciation is recorded as an expense but treated as an add-back on the cash flow statement (CFS) because it is a non-cash item, i.e. there was no real movement of cash.
• Instead, depreciation is the allocation of the initial cash outlay associated with the capital expenditure (Capex), i.e. 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” expense is virtually identical conceptually to depreciation, with the only distinction being that amortization is meant to incrementally reduce the value of intangible assets such as patents and copyright, rather than tangible assets like equipment and machinery.
• Since depreciation and amortization represent non-cash items, yet are still recorded on the income statement per GAAP accounting standards, each expense is treated as an add-back to the operating profit line item (EBIT).
• On the income statement, the D&A expense is rarely broken out in its own separate line item and is instead embedded within either cost of goods sold (COGS) or operating expenses. In order to obtain the entire depreciation and amortization expense of a company, refer to the cash flow statement (CFS), as the non-cash items will be added back to net income as part of the cash reconciliation.

## Why is EBITDA Important?

EBITDA often receives criticism for showing an inaccurate and misleading representation of a company’s actual cash flows.

• Capital Expenditures (Capex): The source of criticism surrounding EBITDA is namely the lack of consideration towards capital expenditures (Capex). For most companies, Capex is a major, recurring cash outflow that is captured on the cash flow statement but the full expenditure does not directly appear on the income statement. Instead, the Capex spend is allocated across the useful life assumption of the fixed asset (in the form of D&A) because the purchased asset is anticipated to provide monetary benefits in excess of one year. While a negligible issue for certain companies, for others the disconnect between EBITDA and free cash flow (FCF) can become substantial, especially for capital-intensive companies.
• Change in Net Working Capital (NWC): The change in net working capital (NWC) refers to the increase or decrease in the operating current assets and liabilities belonging to a company. The change in NWC can have a significant impact on the free cash flow (FCF), yet the cash necessary to fund day-to-day operations is ignored by the EBITDA metric.
• GAAP vs. Non-GAAP Metric: Since EBITDA is a non-GAAP metric, the lack of standardization and the absence of consistency among which items should be included (or excluded) from EBITDA makes it necessary to question the rationale of each adjustment on its own.

Still, EBITDA is widely used across all fields of corporate finance due to the ease of calculating the metric (i.e. ”back of the envelope”), in spite of all the criticism.

The usage of the EBITDA profit measure is particularly common in corporate valuation and mergers and acquisitions (M&A), where the metric is frequently part of the offer price, i.e. the purchase price expressed in the form of a valuation 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 of the company – i.e. the reliance on debt or equity to fund day-to-day operations and purchases – comparisons among companies with different capitalizations are still feasible.
• Non-Cash Add-Backs: The EBITDA metric, by virtue of being a non-GAAP 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, such as 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 the impairment of inventory and property, plant and equipment (PP&E) lead to write-downs and write-offs for bookkeeping purposes, which can affect a company’s GAAP-based financials in the absence of adjustments. Considering such events are non-recurring and non-operating expenses (or income), the removal of their effects would be rational for purposes of forecasting and peer comparisons.

## What is a Good EBITDA?

The EBITDA profit metric by itself, i.e. as a standalone metric, does not offer much insight into either how much a business is worth or its recent financial performance.

However, a company’s EBITDA can be divided by its 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 ratio between EBITDA and revenue, expressed as a percentage, can determine a company’s operational efficiency and capacity to produce sustainable profits over the long run.

• Historical Comparisons → Once expressed in percentage form, a company’s EBITDA margin can be compared to its historical periods to determine the trajectory of its latest performance (i.e. upward or downward trend).
• Industry Benchmarking → In addition, a company’s EBITDA margin can be used for benchmarking purposes, wherein comparisons are made to its closest industry peers.

Therefore, 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 lifecycle, at the very least.

But even if all of the information and data points mentioned were collected, the norm is to avoid making direct comparisons of gross figures without standardizing the metric, i.e. the reliance on the EBITDA margin is the recommended approach, which is practically abided by the entire finance industry.

## EBITDA Bridge: Top-Down vs. Bottom-Up Forecasting Method

Forming an opinion on the discretionary adjustments to EBITDA not only reduces the risk of inflating the metric but also improves the forecasting of EBITDA.

There are two methods by which EBITDA can be forecasted:

1. Top-Down Approach → The top-down approach begins with operating profit (EBIT) from the income statement and adds back D&A from the cash flow statement.
2. Bottom-Up → On the other hand, the bottom-up approach starts with net income (i.e. the “bottom line”) and adds back taxes and the interest expense to arrive at EBIT, with the final step consisting of adding back D&A.
Top-Down EBITDA = Forecasted EBIT + Depreciation + Amortization
Bottom-Up EBITDA = Forecasted Net Income + Taxes + Interest Expense + D&A

## EBIT vs. EBITDA: Non-GAAP Reconciliation

The operating profit (EBIT) of a company is an accrual-accounting-based GAAP profit measure, whereas EBITDA is a non-GAAP, hybrid profit metric.

EBITDA and EBIT are two 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 exclusion of depreciation and amortization in the case of EBITDA (or inclusion for EBIT) is the primary differentiating factor between the two metrics, with the percent differential between the two metrics contingent on the industry (and company-specific).

In certain scenarios, the difference between the two will be marginal, whereas the difference can be “night and day” in other cases (i.e. capital-intensive companies with significant D&A).

• EBITDA → The operating expenses incurred by a company, except for non-cash items (D&A), are subtracted from revenue.
• EBIT → The operating expenses incurred by a company, except for non-cash items (D&A), are subtracted from revenue.

From a high-level perspective, the objective of presenting EBITDA is to offer investors a “normalized” view of financial performance, the outcome should, at least in theory, result in a more accurate depiction of the company’s profitability, which sets the foundation for forecasting.

• GAAP Financial Measures → GAAP metrics such as operating income (EBIT) and net income strictly abide by the accrual accounting reporting standards.
• Non-GAAP Financial Measures → In practice, equity analysts and investors alike often pay more attention to non-GAAP metrics. Non-GAAP metrics are not reported on a company’s financial statements directly – i.e. EBITDA cannot appear on the income statement – yet companies still frequently present their non-GAAP metrics in management presentations and press releases, as well as mention them on earnings calls.

## EBITDA Calculator – Excel Template

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

Submitting ...

## Step 1. Operating 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 EBIT, which is equal to gross profit minus operating expenses, i.e. the SG&A and R&D expenses in our scenario.

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

From the operating income line, the next section is the non-operating income / (expense) section, where our only item is \$5 million in interest expense.

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

• Interest Expense, net = –\$5 million
• 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 EBT.

Here, we’ll assume a tax rate of 20% and multiply that by our EBT, which comes out to \$8 million in taxes

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

• Taxes = –\$8 million
• Net Income = \$40 million – \$8 million = \$32 million

## Step 2. Income Statement Build

Using the operating assumptions from earlier, our completed income statement is shown here.

In Excel, the bolded figures in the table will be calculations (i.e. black font color), whereas the unbolded figures will be inputs (i.e. blue font color).

By abiding by the industry-standard formatting conventions, the chance of a mistake reduces substantially and also makes the process of auditing financial models easier.

Income Statement 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

## Step 3. EBITDA Calculation Example (Top-Down Bridge)

Our next section is comprised of two parts, where we’ll calculate the EBITDA of our hypothetical company using the income statement built in the previous section.

But before we can calculate the metric, we’re missing one key assumption: the depreciation and amortization (D&A) expense.

If we assume the D&A expense recorded in 2021 is \$5 million, what is the EBITDA of our hypothetical company?

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

Under the “top-down” approach, 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.

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

• EBITDA = \$45 million + \$5 million = \$50 million
• EBITDA Margin (%) = \$50 million ÷ \$100 million = 50%

## Step 4. EBITDA Calculation Example (Bottom-Up Bridge)

In contrast, the “bottom-up” approach starts with net income, i.e. the profit metric inclusive of all operating and non-operating expenses found at the bottom of the income statement.

From net income, we’ll add back taxes, interest expense, and D&A to arrive at an implied EBITDA of \$50 million (and a 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%

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