What Is EBITDA In Simple Terms?

EBITDA is earnings before interest, taxes, depreciation and amortisation.

EBITDA is earnings before interest, taxes, depreciation and amortisation. To calculate EBITDA in simple terms, start with profit before tax, deduct interest income, and add-back interest expense, depreciation and amortisation. All these amounts are easily found on a business’s financial statements.

It’s important to highlight that the interest referred to in the acronym EBITDA, is both interest income and interest expense.

With that said, how is EBITDA calculated in simple terms?

How is EBITDA calculated in simple terms?

The best way to calculate EBITDA, is to look at a company’s profit and loss, which will be a page included in its financial statements.

On the profit and loss page, you should be able to find the profit before tax number, which is your starting point.

Then identify any interest income on the profit and loss, and deduct this amount from the profit before tax amount.

Then identify any interest expense on the profit and loss, and add this amount back to the profit before tax figure.

Finally, turn to the page in the financial statements which discloses depreciation and amortisation, which may be on the face of the profit and loss, depending on the detail included on this report, and add back both depreciation and amortisation to the profit figure.

This adjusted profit before tax figure will be EBITDA.

Is EBITDA flawed?

Many argue that EBITDA is flawed, so let’s take a look at this question.

There are many people, including many business brokers, who use EBITDA as a metric to value businesses, which to others, including Warren Buffet, makes no sense.

The reason this makes no sense, is because depreciation and amortisation are expenses of the business, especially depreciation.

Depreciation is a cost to the profit and loss, and a deduction that is calculated so as to charge a percentage of the company’s asset usage in the business. Depreciation is normally calculated on the basis of an asset’s useful life.

If you like, it makes sense to consider depreciation akin to setting aside an amount each month or year sufficient to replace the assets in the future.

Which means, if depreciation isn’t included as a deduction from profits, when calculating a business’s value, the business will be over valued if EBITDA is used for business valuation purposes.

These assets will need to be replaced at some point in the future, and by ignoring depreciation, the business will be over-priced, so that when these assets need replacing in the future, the buyer of the business is effectively paying again for these assets.

This problem is made worse when considering businesses which are heavily invested in plant and machinery, like businesses with a factory.

Where a business has large amounts of plant and machinery, the depreciation charge will be higher, and therefore the add back will be equally as high.

But then on the basis of using the multiplier method, to value a small business with a factory and high levels of depreciation, if EBITDA is used as the profit to be multiplied in the valuation calculation, the business will be much more over-priced.

If you have any questions on this topic about buying a business, or on any other aspect about the process involved in buying a business, please drop a comment below.

And always remember that no question is a stupid question, if you don’t know it, you don’t know it, and by having the answer to a question you have, might be all it takes to move to the very next step in your journey to buy a business.