What is EBITDA? Meaning, formulas & examples

EBITDA is a financial metric to measure a company’s profitability—similar to net income, but with a twist—since it focuses more on cash flow and how efficiently a business runs. EBITDA stands for: 

• Earnings
• Before
• Interest
• Taxes
• Depreciation
• Amortization

Keep reading to learn more about how EBITDA works, why it matters and its limitations.

What you’ll learn:

• Introduced in the 1970s, EBITDA generally uses two formulas 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 potentially provide a skewed picture of profitability.
• Several variations of the metric, like EBIT, adjusted EBITDA, EBITDAR and EBITDARM, are available—each suited to different uses.

EBITDA was first introduced in the 1970s by investor John Malone as a way to measure how much cash telecom companies could generate. These companies had heavy depreciation and amortization costs, so EBITDA helped focus on their core cash flow. By focusing on earnings before these noncash expenses, EBITDA provided a clearer picture of their core financial performance. By the 1980s, EBITDA became the go-to metric, especially for investors trying to turn struggling companies around.

Today, EBITDA is still widely used to evaluate financial performance, but it has its limitations. Since it excludes key expenses like taxes, interest and capital costs, it can sometimes paint an incomplete picture of profitability.

There are a few reasons why business owners and stakeholders use EBITDA, including 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: By ignoring nonoperating expenses, EBITDA provides a picture of a company’s operational cash flow, making it a valuable tool for assessing whether a business can meet short-term financial obligations.

• Attract investors: Investors may choose to use EBITDA as a valuation tool because it cuts out variables that can cloud a business’s true 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 on operating profit.

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

The 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.

The formula is:

EBITDA = Operating Profit + Depreciation + Amortization

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

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.

The margin is calculated by: EBITDA / Revenue.

Let’s consider the hypothetical financials of a start-up with an annual revenue of $5,000,000:

• 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. These noncash expenses reduce profits on paper but don’t actually take cash out of your pocket.

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

EBITDA = $750,000

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

EBITDA margin = 15%

What this number tells business owners, investors or stakeholders is that after accounting for all financial expenses, the company generates $750,000 in cash; this reflects a healthy level of profitability since EBITDA is 15% of the total revenue.

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%

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.

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 and 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 calculates 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 apply 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 or 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 to the bottom line.

EBITDARM, which stands for EBITDA plus rent and management fees, focuses on a business’s performance and cash flow potential without the impact of variable or negotiated costs. It is commonly used in industries where rent and management fees represent significant operational costs.

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

EBITDA has a few limitations to consider before deciding if it’s the right metric for assessing your business’s finances.

First, EBITDA isn’t recognized under Generally Accepted Accounting Principles (GAAP), a set of accounting standardized rules for financial reporting—since it excludes certain financial factors and may result in an incomplete picture of profitability and financial health.

EBITDA also ignores shifts in working capital and capital expenditures—both essential to understanding cash flow; this may lead to an inflated view of a company’s ability to sustain profits or cash flow over time.

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.

If you’re looking to support your company at scale, partnering with Capital One is a great first step. Start by comparing Capital One business cards for the features and benefits that suit your growing business’s needs.