Understanding EBITDA: What it is and how it impacts businesses

EBITDA can be an important metric for understanding business performance and attracting investors. While many companies use net income to measure business growth, EBITDA is a popular solution for gauging financial health.

Whether you're looking to measure cash flow, compare your profit to competitors, or sell your business, it's important to understand how EBITDA works.

Here, we'll explain what EBITDA is, how to calculate it, and how it can impact your business.

What is EBITDA?

First, what is EBITDA? EBITDA stands for “earnings before interest, taxes, depreciation, and amortization." Easy to see why it's shortened to an anagram, right?

EBITDA represents a company's operating profitability before considering non-operating expenses (i.e., interest, taxes, depreciation, and amortization).

EBITDA can be a useful metric for understanding a company's financial performance and valuation. For example, a buyer may compare the EBITDA of a few companies to analyze their profitability and decide which one to acquire.

Components of EBITDA

Now let's break down five key EBITDA components:

  • Net income: Business earnings after deducting expenses.
  • Interest: Interest paid on business loans or lines of credit, such as real estate loans or equipment loans.
  • Taxes: Federal, state, or local income taxes paid by your business.
  • Depreciation: The amount by which the value of tangible business assets, such as vehicles or buildings, decreases over time.
  • Amortization: The amount by which the value of intangible business assets, such as patents or trademarks, decreases over time.

How to calculate EBITDA

Calculate EBITDA for your business by using this formula:

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

Here's an example of how a business can use this formula:

  • Determine net income: A company generated $200,000 in annual revenue. They spent $50,000 on operating and non-operating expenses. So their net income is $150,000. ($200,000 - $50,000 = $150,000).
  • Add interest: The company paid $4,000 in interest expenses, such as for a small business loan.
  • Add taxes: The company paid $3,000 in combined federal, state, and local taxes.
  • Add depreciation and amortization: The value of the company's tangible and intangible assets decreased by $9,000.
  • Calculate EBITDA: EBITDA = $150,000 + $4,000 + $3,000 + $9,000 = $166,000.

Advantages of using EBITDA

There are many benefits of having an EBITDA calculation for growing businesses, especially those working with investors or stakeholders.

Calculating your EBITDA can help you:

  • Better understand the fair value of your business.
  • Compare your business to others in your industry since it eliminates variables like taxes and interest rates.
  • Measure your cash profits and operating performance.
  • Attract potential buyers and investors.

Limitations of EBITDA

Still, relying solely on EBITDA for financial analysis can be risky. While EBITDA can provide a foundational understanding of business profits, it may not represent a company's true financial health. That's because it doesn't take expenses like taxes and interest rates into account. In other words, a business can still have a strong EBITDA even if they're buried in high-interest loans.

EBITDA is also not recognized by the Generally Accepted Accounting Principles (GAAP) standards of the U.S. Securities and Exchange Commission.1 Meaning, businesses may use and interpret EBITDA calculations in different ways.

EBITDA vs. net income

EBITDA and net income are two different metrics that you can use to determine your company's value and profitability.

What's the difference between them? Net income is a calculation of your total earnings after paying all expenses — including interest, taxes, depreciation, and amortization. On the other hand, EBITDA is a calculation of your earnings after paying only operating expenses. So, to calculate EBITDA, you won't subtract any money spent on interest, taxes, depreciation, and amortization.

Both EBITDA and net income each have their use cases. For instance, EBITDA can be used to determine a business's ability to earn a profit. Meanwhile net income can be used to better understand the overall financial health of a business. If revenue is much higher than net income, a business may need to cut down on certain expenses.

It's also important to understand net income for tax purposes, as this metric can determine how much a business pays in taxes.

Using PayPal to manage your business

As you grow your business, consider using EBITDA along with other metrics to better understand the financial health of your company. Especially if you're looking to attract investors or even sell, EBITDA can help position your business against competitors and demonstrate your profitability.

You can also use a platform like PayPal to manage and streamline everyday operations. From tracking sales to sending payments, PayPal can help — so you can get back to running your business.

Learn more about getting started with PayPal for Business.

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