EBITDA is one of the essential metrics to measure a business's performance and value. To a layman, the measure of a company's financial performance and profitability is its revenue. However, financially savvy individuals such as investment bankers, financial analysts, managers, creditors, and business owners do not just quantify a business based on its income.
This article will answer these questions and more.
What is EBITDA?
EBITDA is "Earnings before interest, taxes, depreciation, and amortization." EBITDA is a company's net income with taxes, interest expenses, depreciation, and amortization added back.
It attempts to showcase the ability to generate cash flow from a company's operations, excluding non-cash expenses and costs related to its capital structure. Excluding these costs reduces the company's discretionary power over certain cost factors such as capital structure, debt servicing, taxes( which may not be paid immediately ), and its depreciation method.
How to calculate EBITDA?
There are two ways of calculating EBITDA if it is not included in a company's financial report.
Breakdown of EBITDA components;
Interest is the cost used to service the company's debt. Interest is excluded when calculating EBITDA because it concerns the company's capital structure. A typical company's capital structure is made up of debt and equity. A company may have varied credit sources, resulting in more interest costs.
Tax is an ongoing cost that has nothing to do with business performance. It's not an operating cost; it depends on the laws of the business jurisdiction. As such, financial analysts prefer to consider it only when assessing a company's operational performance, although it may be added back when comparing two companies for investment purposes.
Depreciation & amortization
Depreciation and amortization (D&A) are costs related to the company's long-term fixed asset, which may gradually depreciate in value. Depreciation is linked explicitly to tangible assets like equipment that may be devalued over time due to wear and tear. Amortization relates to the company's intangible assets, like patents or websites with expiration dates.
Analysts exclude D&A from EBITDA because it is a non-cash expense related to historical investments and has little or no significance on the company's operating performance. Aside from that, its calculation is primarily based on assumptions about the asset's salvage value, useful economic life, and the company's depreciation method.
Net income is the firm's earnings after the deduction of all operating costs ( cost of goods sold, selling, general, & administrative expenses (SG&A)) and non-operating costs (interest, tax, depreciation, and amortization ). Net income is not considered a good measure of a company's performance and profitability because it considers non-operating expenses. Non-operating expenses obscure business valuation as it does not reflect actual performance.
Some of these costs are beyond the company's control, while others are self-inflicted. A company's tax may be higher or lower due to a new tax. Higher interest may be a result of unhealthy debt decisions. Non-cash expenses like depreciation and amortization are primarily based on assumptions that managers may manipulate. As such, investors prefer to add back all these non-operating expenses and only take cognizance of costs that are inevitably related to business operations to view the company based on its real capabilities.
All these line items can be found in a company's financial statement.
A company's net income, interest, and tax can be found in its income statement. Depreciation and amortization are in the cash flow statement or supporting notes to the operating profit.
Example of EBITDA
A construction company generated a $500,000 net income. The company paid $50 000 as interest to its various creditors. Based on the country's tax law, the company's income tax was $100 000. Depreciation and amortization of its asset was valued at $20,000
EBITDA= $500,000+ $50,000 + $100,000+$20,000
What is revenue?
Revenue is the income generated by a business through its primary operations and other income streams, such as sales of goods or services, rent on properties, interest on credits, and dividends from investments. Revenue measures sales activity and more, as there are several non-operating revenues. Revenue also covers all debts the company is owed.
Revenue is the company's income before subtracting expenses and costs during an accounting period. Subtraction of fees and expenses will give you net income. Because revenue is displayed at the top of the income statement, it is called the top-line figure. Revenue may be tracked per accounting period, which may be annually or quarterly.
EBITDA vs. revenue
EBITDA and revenue are both metrics that can be used to measure a company's financial performance. However, EBITDA vs. Revenue differ based on definition, use, calculation, and general acceptability.
Revenue is the total income generated by a company from its primary operations and other sources of income before deducting any expenses and recurring costs. Revenue includes both cash at hand and arrears expected from debtors.
EBITDA means earnings before interest tax, depreciation, and amortization. Although EBITDA measures a company's revenues, some operating expenses and costs have been deducted. It only includes net income and non-operational expenses such as interest, tax, depreciation, and amortization.
Revenue, on the other hand, is earnings before any costs and expenses are deducted.
Revenue is a crucial top-line figure on the income statement. Revenue indicates the company's cash flow and is used to measure its sales activity. While it may not reveal profit or loss, it can be used to measure a business's market success. Revenue can be described as the lifeblood of the company. Its increase and decrease will have a significant effect on business performance.
Revenue is an important metric because it shows the performance of each income stream and overall business performance. Such insight can be helpful in the decision-making and allocation of resources. Tracking your revenue growth can give insight into your earning pattern, whether your income is increasing or decreasing over time, and the factors responsible for such fluctuations.
Using revenue, you, your accounting team, and your chief financial officer can analyze your historical revenue performance to gain insight into factors that may affect your earning potential and ultimate profitability.
On the other hand, EBITDA is a baseline income statement figure used to measure a business's profitability and ability to maintain its operating expenses. EBITDA is an important metric for investors and business managers as it shows cash profit generated from the business's operational activities.
EBITDA is used in business valuation to determine business profitability and how well it is being managed by excluding factors unrelated to the management's operational control from its calculations.
Companies' chief financial officers and business managers can also evaluate their company's performance by comparing its EBITDA to similar companies' reported EBITDA.
A company's revenue can be calculated by adding all income from its operational activities, non-operational activities, and debts other businesses and individuals owe the company.
EBITDA can be calculated by adding interest expenses, tax, depreciation, and amortization to its net income.
Based on Generally Accepted Accounting Principles (GAAP) established by the Financial Accounting Standards Board (FASB), revenue is an item that can be reported on a company's income statement.
Despite its usefulness, EBITDA is not recognized under the US Generally accepted accounting principles (GAAP) and
International Financial Reporting Standards (IFRS). It is claimed that EBITDA inflates a company's profitability. It is not considered a meaningful measure of a company's performance. Some sage investors like Warren Buffet show disinterest in EBITDA because it doesn't consider asset depreciation which is a significant expense for some companies with a lot of depreciated assets with higher costs of maintaining them.
Although some public companies include EBITDA in their quarterly report, the SEC requires companies doing so to explain how they came about such figures and reconcile them with their net income.
What's more critical, revenue or EBITDA?
Both Revenue and EBITDA are essential metrics for managers and investors. However, EBITDA can be considered more important because it presents a realistic view of business performance.
Revenue can be misleading. It can show business profit or loss since operating expenses and costs have not been deducted. Although EBITDA also excludes specific fees in its calculation, it gives a clear view of a business's operating capability and efficiency. After removing the company's operating expenses, profit or loss can be deduced. Ultimately it is a better measure of the value of a company.
What is a good ratio of EBITDA to revenue?
It calculates a business's operating profit or EBITDA as a percentage of its revenue. It compares a company's gross revenue to its income. The ratio of EBITDA to revenue indicates the EBITDA margin; it is also called the EBITDA to sales ratio.
The EBITDA margin is a metric used to measure a company's profitability based on its operations. EBITDA margin considers a company's cash flow and operational capability leaving out non-operational expenses. As such, investors use this margin to compare companies of different sizes in the same industry based on their actual performances.
EBITDA margin can be calculated using this formula:
EBITDA margin= EBITDA / total revenue
The higher the EBITDA margin, the higher the profitability. In contrast, a lower EBITDA margin indicates lower profitability, and it shows how a company can lower its expenses while maintaining higher income and stable cash flow.
EBITDA margin shows how a company's operational expenses affect costs relative to its revenue. It shows how a company can lower its expenses while maintaining higher income.
Although some analysts consider 10% a good EBITDA margin, a good EBITDA margin is relative. It varies based on industry. And when comparing companies, investors will choose a company with a higher EBITDA margin.
Aside from EBITDA margin, several other EBITDA variations like EBIT( Earnings before interest and taxes) and
EBITA (Earnings before interest, taxes, and amortization) can be used to measure a company's profitability relative to its peer.
Why are EBITDA and Revenue important metrics to investors
When making investment decisions, investors and analysts need to value a business to ascertain its capability to generate cash flow to sustain its operation and generate handsome returns for shareholders.
EBITDA and revenue are considered important metrics when making investment decisions. These metrics are essential because they show business performance and financial health in real time by ignoring non-operating expenses.
Importance of EBITDA to investors
Investors and financial analysts consider EBITDA an important metric during business valuation because it eliminates the effect of a company's capital structure, government policy, and accounting decisions to provide a clear picture of its performance and profitability.
EBITDA is considered valuable compared to other metrics during valuation. It gives analysts a clear picture of a company's operational profitability by excluding the effect of non-operational management decisions such as tax, interest, depreciation, and amortization. Such operational profitability makes it easy to compare companies based on investors, owners, and stakeholders.
In mergers and acquisitions, the EBITDA multiple is an excellent financial ratio used to value a company compared to similar firms with different market capitalizations. It involves comparing a company's Enterprise Value to its annual EBITDA( EV/ EBITDA). Enterprise Value means the total value of a company's debt and equity.
EV/ EBITDA ratio allows investors to compare companies with different capital structures. Unlike Equity market capitalization( total value of a company's shares), the EV/EBITDA ratio shows investors the actual value of a business. It will reveal whether a business is undervalued or overvalued because it includes the company's debt capital and total equity. A company with a high ratio is considered overvalued compared to a lower one, potentially undervalued.
EBITDA Multiple( EV/EBITDA ratio) = Enterprise Value ÷ EBITDA
Enterprise Value = market capitalization +market value of debt - cash and equivalents
The importance of EBITDA also comes into the limelight during stock picking for investment. EBITDA margin gives an insight into a company's operational efficiency and growth potential. Investors can also forecast a company's ability to fulfill its debt requirements through the EBITDA-to-interest coverage ratio. The EBITDA-to-interest coverage ratio shows a company's capability to pay interest on all its outstanding debts.
Importance of revenue to investors
Investors use the revenue to measure a company's prospects. It shows a company's market capitalization and demand for its products or services. It can measure a company's value based on its sales activity.
Investors use revenue multiples to value a company in relation to the income it generates or net sales. Revenue multiple is used to value startups because they often struggle to make a profit at their early stage. It is often used to value small enterprises and startups, stating negative profit margins that can not be valued with conventional valuation multiples like EV/EBIT or EV/EBITDA.
Such companies are valued using Enterprise Value to Revenue Multiple (EV / Revenue).
The revenue Multiple is also called the price-to-sales ratio. It is a helpful tool for investors and valuation analysts. It is used to compare a company's stock price to its revenue. It shows how much investors are willing to pay per dollar for each company's stock. The price-sale ratio can be used to compare companies in the same sector.
A price-to-sales ratio higher than average may indicate that a company's stock is overvalued, while a lower percentage may indicate undervalued.
It can be calculated by dividing a company's market capitalization by its total sales over a specific period. You can use this formula.
P/S Ratio=SPS/MVSMVS=Market Value per Share
SPS=Sales per Share
Enterprise Value to sale(EV/sale) is another helpful valuation tool for investors. It compares a company's Enterprise Value to annual sales. EV/sale is metric investors and analysts use to value a company based on its annual sales while considering its debt and equity. EV/sale is more accurate than price-to-sale because it considers the company's debt profile. A lower EV/sales may indicate that a company is undervalued, which makes it a good investment.
EV/Sales= MC+D−CC/ Annual Sales
CC=Cash and cash equivalents
EBITDA and revenue are both valuable metrics used to calculate business performance. The primary difference between EBITDA and revenue is that EBITDA is a company's total income minus operating expenses. On the other hand, revenue is a company's total income before deducting any expenses.
As a business owner or investor, it is crucial to understand these and other business valuation metrics to make strategic business and investment decisions. But do remember that these metrics alone are not enough to safely gauge your company's financial health.