Accountants are known for their financial models, mumbo-jumbo, and of course their acronyms. One of the most touted acronym of them all is EBITDA. Unfortunately, most business owners (especially small business owners) don’t understand the meaning of EBITDA. And those that understand what the acronym is saying, they still may not completely understand the value of knowing this figure.
In this article, I hope to break down the basics of EBITDA, and how it can be used as apart of your financial strategy.
Breaking Down the Acronym
EBITDA stands for Earnings BEFORE Interest, Tax, Depreciation, and Amortization.
Interest refers to interest paid on company debt.
Tax refers to any and all tax paid out by the company.
Depreciation is the write off loss taken by the company for aging real property and equipment.
Amortization refers to captured equity through the paying on principal in any given loan.
Interest on loans for a smaller company is likely to be more expensive than a bigger company. Smaller and newer companies are likely to have less credit history, so the interest rates they are given on their debt tends to be higher.
Depending on the entity’s structure, businesses will have an increased percentage of tax liability as their profits increase. Tax liability can make it difficult to compare two similar companies at different financial stages.
Mature companies tend to have more real property on their balance sheet. Since they are able to write off a percentage of that property’s value each year, it can weight on the net income number on the profit and loss, making it seem like the company made less than it did. Good for taxes, not so good on paper though.
Amortization refers to the paying of principal on a loan. On paper, amortization is recognized as a capture of equity. Even though it is a draw on cashflow, it is lumped in with the net income number.
Why Use EBITDA?
Why would we need to know what earnings are before interest, tax, depreciation and amortization. Aren’t these figures important to understanding a business’s financial health?
Yes, of course. It is not to say these things don’t matter, because they do, very much so.
The reason for using EBITDA is to compare two companies within the same industry that have very different financial situations.
Company A who is making $500,000 in annual revenue, may have a very different net margin versus Company B who is making $5,000,000 in annual revenue.
Using EBITDA levels the playing field making companies within an industry easy to compare.
Read my Linkedin post regarding EBITDA.
Have More Questions?
Feel free to block off 15 minutes in my calendar for a quick phone call. Ask any questions you would like!