How is EBITDA calculated and what is it used for?

Within the financial sector, there are many calculations to be made, topics to go over and terms to handle that can be confusing...

But, if you are going to be in charge of a business, the best thing you can do is prepare yourself to understand well all the issues you will have to face.

Yes, we know, it's something that can be annoying and at first there are topics that seem difficult to understand, but don't be discouraged, it's all a matter of taking it step by step.

Among the main things you must learn to deal with are the terms formed by acronyms, such as the case of EBITDA, an acronym that at first glance seems to be the name of a company.

However, its meaning and, above all, its financial implication, is much deeper.

That’s why you need to learn what it means, when you will have to deal with it, and, above all, how EBITDA is calculated.

If you are already facing the first situation in which you encounter this term, don't worry, we will take action to explain what you need to know about this topic: 

What is EBITDA?

Without a doubt, the first thing to clarify is what EBITDA is, because without understanding what it is, you will not be able to understand how to calculate it, much less understand the implications it has.

Therefore, you should know that EBITDA stands for earnings before interest, taxes, depreciation, and amortization.

Simply put, it’s the monetary profit you make before subtracting interest, taxes, depreciation, and amortization.

Therefore, EBITDA can be understood as an accounting indicator that allows you to analyze the profitability of a company.

Within the financial sphere, this indicator is one of the alternative performance measures that provide much more accurate financial information, since, for its calculation and respective application, it uses the financial statements of a company and applies the corresponding accounting regulations.

Why is it so important to use EBITDA?

If you are new to financial topics, it’s normal for you to have doubts about each of the new terms that pass in front of you.

Because of this, it’s also quite common for you to have doubts about the level of importance of using each of these financial terms in your company's activities.

However, there’s no doubt that EBITDA is an indicator that is fundamental and its use, nowadays, has been quite globalized.

That’s why in Spain it’s quite common to use it, regardless of the level of your company, since it’s used to assess a company's capacity to generate profits. This, taking into consideration only its productive activity, which is possible because EBITDA shows the result obtained by the operation of the business in question.

It should be noted that, as this indicator does not fully include all the company's expenses, it is possible to visualize more clearly how much money is left to pay outstanding debts.

So, yes, it’s an important financial term, but it should be noted that, as it isn’t the only one that exists, there are businessmen who prefer to work with others.

How to calculate EBITDA?

Now, the moment of truth has arrived, and surely the reason why you are in our blog today, it’s time to learn how to calculate EBITDA.

At this point, it’s essential that you recognize the definition of another term: EBIT.

EBIT refers to earnings before interest and taxes. In other words, it’s the amount of money that shows the gross profit from the operation of a company.

Therefore, to calculate EBITDA, you will have to add to your EBIT the company's expenses and provisions for depreciation and amortization.

In this way, you will be able to have as a result the pure, gross, or full amount that the company has generated, and that represents the productive force of the company.

So, now you know, the next time you want to make this calculation, you should use this formula: EBITDA = EBIT + depreciation expenses + amortization expenses.

How to read the result obtained in EBITDA?

Now, the goal isn’t only obtaining a result, but knowing how to interpret it in order to measure the profitability of the business.

In case you get a positive result after calculating EBITDA, you can rest assured. This means that you have a profitable company in terms of its operating level.

On the other hand, if it’s negative, it means that the company is poorly managed or there is some kind of operational difficulty that needs to be analyzed.  

However, this is when it should be noted that EBITDA can present misleading results.

Take for example a company that has invested a lot of money in intellectual property or capital assets.

In that case, it will certainly have a positive EBITDA result, but this doesn’t mean that the business is actually profitable.

What is EBITDA really for?

As we have reviewed so far, EBITDA is an indicator that allows companies to recognize their own financial health.

Therefore, if it were not for it, we would not be able to have a clear idea of the cash flow available or the main profits that the company is generating.

Now, in addition to these, which are just the basic reasons, it’s also necessary to recognize the purpose of calculating EBITDA, which we will explain below:

1. Making comparisons between companies in the same industry.

Undoubtedly, the main usefulness of an indicator such as EBITDA is that it makes it possible to compare companies belonging to the same labor sector.

Thanks to this, the analysis carried out within the company can be much more accurate.

Furthermore, based on this, it’s also possible to standardize the business performance to bring it up to the industry average.

2. Accurately calculating the DSCR

Another aspect to take into account is that thanks to EBITDA it will be easier to calculate the DSCR (debt service coverage ratio).

Keep in mind that banks use EBITDA to calculate this other indicator.

Since the DSCR is in charge of presenting the debt-to-income ratio of the company. In this way, it’s possible to measure the cash flow that a company has, in order to pay some kind of loan.

Therefore, when you go to a bank with the intention of requesting a loan for your company, the bank will ask you for the EBITDA in order to calculate the probability of default on the loan in question.

As you can imagine, if your EBITDA result is negative, your DSCR will also be negative, which translates into a high probability that your bank loan application will not be accepted.

3. Getting a complete picture of business performance

Now, to conclude, it should be noted that the use of an indicator such as EBITDA is also useful to get an overview of a company's performance.

By analyzing EBITDA, you will have the opportunity to have a clear picture of your company's long-term potential.

That way, you will be able to anticipate whether it’s a profitable business or a company that will not take you very far.

Things to keep in mind when analyzing EBITDA

In order to use EBITDA without confusion, it’s important to clarify some points.

Remember that, as we’ve already mentioned, EBITDA is one of the many indicators that can give you specific insights into the financial state of your company.

Therefore, it’s important that you don’t confuse it with other main indicators, as this would cause complications when reading the results.

So, in order for you to be aware of how to use EBITDA well, it’s important that you recognize these considerations:

You should not substitute it or confuse it with cash flow.

Although it’s useful for comparing companies, the quality of earnings would allow you to perform a much more in-depth analysis on the subject.

Remember that the profit shown by EBITDA excludes some expenses that are still mandatory to meet.

4 Tips to Improve Your EBITDA Performance

We are well aware that, if you are already headlong into a specific company, you don't want to leave it behind.

That's why, before you think about abandoning the company project you have already set up, you should try to improve your EBITDA result first.

Yes, this is something possible, although it requires a little more effort and perseverance on your part and on the part of the company's management.

Of course, you should know that this is something you would do at your own risk, as it will depend very specifically on the state of your company whether this is something that will work for you or not.

However, it never hurts to try, so if you want your EBITDA to improve, we recommend you follow these tips:

1. Manage inventory to increase capital

Inventory is one of the most important aspects of any company and one over which you should have better control.

That’s why one of the first things you should do is improve the way in which the company's inventory is being managed.

This can be translated as improving the balance between the manufacturing process and sales. Which, as you can imagine, will keep things moving within the company.

2. Maintain product prices and reduce investment costs.

Many people, when they are immersed in a business crisis situation, think that the best thing to do is to increase the prices of the products or services they sell in order to obtain a higher profit.

But this is a terrible mistake since it could even cause many of your regular customers to stop working with you, something you certainly do not want.

For that reason, instead of doing this, try to keep your prices down and choose to work with distributors that offer cheaper prices, in order to maintain your profit margin.

3. Optimize the management of travel expenses.

Now, if you have a company that usually spends a lot of money on travel for meetings and so on, you should start thinking about optimizing the management of the money you invest in it.

Analyze this aspect and see if you can reduce the number of people traveling each time or, alternatively, opt for a virtual mode for meetings so you don't have to travel as often.

4. Make changes to the commission plan

Sales commissions are one of the most appealing aspects to all your employees, which is why making some small changes in your commission plan can generate great business results.

A good example of this would be to reward a little more for sales that close before the end of the year. That way, your employees will strive to find a greater number of customers willing to close deals with your company.

As you can see, even though EBITDA may sound like something completely different at first, it turns out to be a financial indicator that you may need to use within your company.

No doubt, now that you are aware of what it’s all about and the kind of applications it can have, you are ready to calculate it whenever necessary.

Remember that, if you have more questions on topics of this style, on our blog we have a wide range of similar articles on other financial and digital topics that you may be interested in reviewing.