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EBITDA: What it is, How to Calculate

EBITDA is a financial metric used to measure a company’s operating performance. The acronym stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.

EBITDA can be calculated in 2 ways:

  • Top-down: by deducting from revenues all (cash) operating expenses
  • Bottom-up: by adding back interest expense, taxes, depreciation, and amortization to net income

Why do we use EBITDA?

EBITDA is used to provide a clearer picture of a company’s profitability and cash flow because it removes certain non-operational expenses, such as interest payments and depreciation, which can vary significantly from company to company and may not accurately reflect the company’s underlying business performance.

That’s why EBITDA is commonly used by investors, analysts, and lenders to evaluate a company’s financial health, particularly in industries that are capital-intensive and require significant investments in equipment, such as food & beverage, retail or manufacturing businesses.

It is also often used as a key performance indicator (KPI) for executives and managers to track the performance of their operations.

It’s important to note that while EBITDA can provide valuable insights into a company’s financial performance, it has some limitations. For example, EBITDA doesn’t take into account capital expenditures or changes in working capital, which can have a significant impact on a company’s cash flow. Additionally, EBITDA can be manipulated by companies through accounting practices, such as capitalizing expenses instead of expensing them.

Overall, EBITDA is a useful metric to help evaluate a company’s operational performance and cash flow, but it should be used in conjunction with other financial metrics and analysis to gain a complete understanding of a company’s financial health.

How to calculate EBITDA: top-down approach

First let’s look at the top-down approach:

The top-down approach involves starting with a company’s revenue and subtracting its operating expenses to arrive at EBITDA. Here’s the formula for calculating EBITDA using the top-down approach:

EBITDA = Revenue – Cost of Goods Sold – Operating Expenses

Let’s break down each component of the formula:

  • Revenue: This is the total amount of money earned by the company from sales of its products or services.
  • Cost of Goods Sold (COGS): This is the direct cost of producing the goods or services sold by the company. It includes the cost of materials, labor, and overhead directly related to production.
  • Operating Expenses: These are the expenses incurred by the company to operate its business, such as rent, salaries, marketing, and utilities.

Using this formula, we can calculate EBITDA for a company. Let’s say a company has the following financial metrics for the year:

  • Revenue: $2,000,000
  • Cost of Goods Sold: $800,000
  • Operating Expenses: $500,000

Using the formula above, we can calculate the company’s EBITDA:

EBITDA = $2,000,000 – $800,000 – $500,000 = $700,000

How to calculate EBITDA: bottom-up approach

Now, let’s look at the bottom-up approach:

The bottom-up approach involves starting with a company’s net income and adding back certain expenses to arrive at EBITDA.

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

Let’s break down each component of the formula:

  • Net Income: This is the company’s total revenue minus all expenses, including COGS and operating expenses, interest, taxes, depreciation, and amortization.
  • Interest Expense: This is the cost of borrowing money, such as interest paid on loans or bonds.
  • Taxes: This is the amount of money the company pays in taxes to the government.
  • Depreciation: This is the gradual decrease in value of assets over time. Depreciation is a non-cash expense that reduces net income.
  • Amortization: This is similar to depreciation, but it applies to intangible assets such as patents and trademarks.

Now, let’s say a company has the following financial metrics for the year:

  • Net Income: $500,000
  • Interest Expense: $50,000
  • Taxes: $100,000
  • Depreciation: $150,000
  • Amortization: $50,000

Using the formula above, we can calculate the company’s EBITDA:

EBITDA = $500,000 + $50,000 + $100,000 + $150,000 + $50,000 = $850,000