What is EBITDA? Meaning, formulas and examples

EBITDA—short for earnings before interest, taxes, depreciation and amortization—is a financial metric designed to measure a company’s profitability. It’s similar to net income but excludes the effects of financing decisions, taxes and noncash accounting items. EBITDA focuses more on cash flow and how efficiently a business runs.

Keep reading to learn more about what businesses use EBITDA for, how it’s calculated and its limitations.

What you’ll learn:

• EBITDA generally has two formulas that are used to evaluate how much cash a company may generate: one based on net income to estimate profitability and the other based on operating profit to measure efficiency.

• Business owners and stakeholders often use EBITDA for a number of reasons, but because it excludes certain costs, it may provide a skewed picture of profitability.

• Several variations of the metric—like adjusted EBITDA, EBIT, EBITDAR and EBITDARM—are available, with each suited for different uses.

EBITDA is a widely used metric for evaluating a company’s financial performance. By excluding interest, taxes, depreciation and amortization, it highlights how a business performs based on its core operations rather than its financing decisions or accounting methods.

Many business owners and stakeholders use EBITDA to:

• Evaluate profitability: EBITDA zeroes in on a company’s core operations, leaving out costs like taxes, interest, depreciation and amortization. This helps business owners understand how effectively their business generates profit from its day-to-day activities.

• Assess cash flow: Because it adds back depreciation and amortization, EBITDA is often used as a proxy for operating cash flow. While it doesn’t account for changes in working capital or capital expenditures, it can offer insight into a company’s ability to generate cash from operations.

• Attract investors: Investors may choose to use EBITDA as a valuation tool because it cuts out variables that can cloud a business’s overall financial performance. By focusing on operating results, EBITDA gives investors a clearer sense of whether the company is set up to deliver steady returns in the future.

• Simplify financial analysis: Since EBITDA doesn’t consider accounting adjustments related to depreciation and amortization, comparing financial performance across different companies is easier.

To calculate EBITDA, two formulas are generally used: one based on net income and the other based on operating profit.

The net income formula assesses a company’s overall profitability, offering a comprehensive view.

The basic EBITDA formula is:

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

The operating profit formula focuses on a company’s core operations, making it helpful in assessing efficiency.

Here’s how to find EBITDA based on operating profit:

EBITDA = Operating Profit + Depreciation + Amortization

The information and key figures required to apply these metrics are typically found in a company’s income statement.

Consider the hypothetical financials of a startup with an annual revenue of $5 million:

• Net income: $500,000

• Interest: $50,000

• Taxes: $100,000

• Depreciation: $80,000

• Amortization: $20,000

• Operating profit: $800,000

To use the net income-based formula, start with your net income and then add back interest, taxes, depreciation and amortization. Depreciation and amortization are noncash expenses that reduce profits on paper, so EBITDA adds them back.

EBITDA = $500,000 + $50,000 + $100,000 + $80,000 + $20,000

EBITDA = $750,000

You can then calculate the EBITDA margin—the percentage indicating how well a company can generate a strong profit after covering its operating expenses. To find the EBITDA margin, divide EBITDA by annual revenue.

EBITDA margin = $750,000 / $5,000,000

EBITDA margin = 15%

However, when applying the operating profit formula, the EBITDA is slightly higher:

EBITDA = $800,000 + $80,000 + $20,000

EBITDA = $900,000

EBITDA margin = $900,000 / $5,000,000

EBITDA margin = 18%

The number in the first example tells business owners, investors or stakeholders that the company generates $750,000 in earnings from its core operations before accounting for financing costs, taxes and noncash expenses. This reflects a healthy level of profitability since EBITDA is 15% of the total revenue.

As you can see, the results of the two formulas are slightly different. The net income method factors in interest and taxes, while the operating profit method focuses purely on the company’s core operations, resulting in a higher EBITDA. This higher number gives investors and business owners a better understanding of how efficiently the company runs its main operations, like sales or production.

When you convert EBITDA into a percentage, you can:

• Review trends: You can compare your company’s margin to past periods to learn more about the company’s profitability. Is it increasing, decreasing or staying the same? 

• Compare against competitors: The EBITDA margin can also be used to review how your company stacks up against others in your industry.

Whether your company has a good or strong EBITDA margin depends on factors like its industry, business model, size and capital structure. Generally, an EBITDA margin between 10% and 15% is considered good, while a margin under 10% could indicate the business is facing some operational challenges.

In some industries, an EBITDA margin of 15% or more may indicate that the company can generate a strong profit from its revenues after covering operating expenses. But in other industries, an EBITDA margin may need to be at least 25% to be considered good.

Numerous variations of EBITDA exist, each tailored to specific uses or to provide insights into particular aspects of a company’s financial performance. 

Here are some of the most popular variations of this metric and what they are used for:

Adjusted EBITDA is often used to give a clearer view of ongoing operational performance by removing nonrecurring or irregular items, such as legal settlements or one-time gains or losses.

Bottom line: Business owners, entrepreneurs or investors may use this calculation to assess a company’s sustainable operational performance more accurately.

EBIT, or earnings before interest and taxes, is similar to EBITDA and measures a company’s profitability. However, while EBIT excludes the effects of financing and tax strategies, it still includes noncash expenses like depreciation and amortization, which EBITDA doesn’t.

Bottom line: Business owners with substantial fixed assets may use EBIT to get a sense of profitability while considering the costs of maintaining or replacing assets necessary for operations.

EBITDAR stands for EBITDA plus rent and sometimes restructuring costs. It’s often used in industries like casinos or restaurants, where lease expenses can significantly impact profitability, or for recently restructured businesses.

Bottom line: Business owners and investors often use EBITDAR to assess the impact of rental or restructuring costs on the bottom line.

EBITDARM, which stands for EBITDA plus rent and management fees, focuses on a business’s performance by removing the impact of significant contractual costs like lease payments and management fees. It is commonly used in industries where rent and management fees represent a large portion of operating costs.

Bottom line: Private equity firms or business owners may use EBITDARM when considering investment opportunities—particularly for businesses with large rental or management fee structures.

EBITDA can often paint an incomplete picture of profitability, and it may ignore shifts in working capital and capital expenditures—both essential to understanding cash flow. This can lead to an inflated view of a company’s ability to sustain profits or cash flow over time. 

Additionally, EBITDA isn’t defined under Generally Accepted Accounting Principles (GAAP), a set of standardized accounting rules for financial reporting. That’s because EBITDA excludes certain expenses—such as interest, taxes, depreciation and amortization—that are included in GAAP financial statements.

Consider these limitations before deciding whether EBITDA is the right metric for assessing your business’s finances.

EBITDA is a metric that assesses a company’s operating performance. While it provides valuable insight into a business’s profitability, it doesn’t give a complete picture of its financial health because it overlooks important costs like interest and taxes.

Understanding its limitations and combining EBITDA and its variations with other business metrics can provide a clearer picture of your company’s current performance and future potential.

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