EBITDA stands for Earnings Before Interests, Tax, Depreciation and Amortization.
Almost all companies around the world are all in business for the same motive – profit making. Quite simply put, in order to make profit, companies need to generate more revenue than the various costs incurred in the process of carrying out their business.
However, it is important to note that some companies are established to achieve specific purposes order than profits. Example of such firms are public corporations or government-owned business which are often established to ensure that certain products or services are made available to a certain group of people.
These organizations usually rely on funds from the taxes that the government collects from the general public to fund their day to day operations. They typically charge very little or no fees at all in exchange for the products or services that they offer. Examples of public corporations include Public Hospitals, public schools, Waste management companies etc.
Another set of companies that are not profit-oriented are NGOs (Non-Governmental Organizations). They are charity based organizations usually owned and run by private individuals for the purpose of providing certain humanitarian services to the society. Examples of NGOs are: Red cross society, Bill & Melinda Gates Foundation, Amnesty International, Doctor Without Borders etc.
Whether they set out to make Profit or not, every organization incurs expenses and earns some form of revenue in course of their various activities.
Revenue can be defined at the income that a company receives from the products they sell, or services that they render or investments that they make in other businesses. In order to fulfill regulatory requirements and keep track of all transactions, these activities are recorded in several books of accounts.
Sources of Revenue
In accounting terms, companies generally derive their income through 3 main sources. Trading, Financing & Investing activities.
- Trading Activities
This is usually the biggest source of income for most companies. It refers to the income generated from actual sale of products offered and/or services rendered by the company. For instance, trading revenue for a restaurant would be income generated from sale of food and drinks. Cost incurred here may include the purchase of raw food & groceries required to prepare the food that is being sold.
- Financing Activities
This refers to other crucial activities that the owners of a business may carry out which affect the fortunes of the business but are completely un-related to the day to day running of the front-door business activities.
These activities may include trading the company’s equity, paying or re-negotiating or adding debts, renovating, revaluing, selling and/or purchasing assets on behalf of the company such as equipment, machinery, buildings.
All these activities may yield income for the owners of the company such as Interest earnings, Appreciation of Assets, Goodwill etc.
It generally focuses on the way the company raises capital and pays its creditors.
- Investing Activities
Just like we individuals do when we have some spare cash, sometimes, the business owners may decide to invest some of the companies spare funds into the businesses of other companies (usually not competitors) or some classes of income yielding assets such as bonds, short-term securities etc.
The legality of this varies from one industry to the other.
This is another way companies can earn income away from actual trading of their own products or services. Forms of income the organization can earn include, dividends
Costs are the direct opposites of revenue. It refers to the various expenses that a company incurs in the process of carrying out the various activities listed above.
Types of costs and Expenses
Costs incurred in the running of an organization can be broadly categorized into three, Administrative Expenses, Trading Expenses, Financing/Investing Expenses.
- Administrative Expenses
This refers to the general costs incurred by an organization that is not directly tied to one specific business function, department or unit. They are usually related to the organization as a whole. Examples are Executive Managers’ salaries, Rent, Utility bills, Insurance, Legal staff salaries, Accountants Salaries.
Administrative expenses are addressed as such because they are related to the organization as a whole.
- Trading Expenses
These are expenses that are associated specifically with the purchase and sale of commodities on behalf of the businesses. Examples include, cost of raw materials, wages and salaries of sales team, cost of carriage (inwards and outwards), cost of packaging products, discounts allowed to customers.
- Financing & Investing Expenses
When the owners of a company issue equity, trade stock or securities, they often need to employ the services of certain professional dealers or brokers, thereby incurring different costs such as Dividend payments, Brokerage, Commissions and fees.
Profit in lay man terms simply means the excess of Income over Expenditure.
In a nut-shell, Earnings and Expenses are grouped distinctly as such in order to be able to observe the profitability of each Business Unit.
A company’s consolidated financials showing a Profit position does not necessarily mean that every single business unit or departments within it are all making profits and vice-versa.
The knowledge of EBITDA and other measures of profit enable the various users of financial information to make crucial decisions in relation to the business.
Different Measures of Profit
- Gross Profit
This is the profit that a company makes after all costs associated with selling, making and manufacturing its products as well as costs directly related to services it renders from the income generated from same. These are also called Costs of Goods Sold (COGS).
Gross Profit is derived under the Income Statement of a company.
In accounting terms: Gross Profit = COGS – Sales Revenue
- Net Income or Net Profit
Net Profit = Gross Profit + Other Income – Other Expenses
This is excess income left after deducting other cost incurred by the business which are not specifically associated with trading activities. These costs associated with Net Profit must include all financial activities that the company is involved in. i.e both Trading and Administrative activities as we have identified above
Net Income may also include gains and expenses from Financing and Investing activities of the company respectively. However, not all companies get involved in these ‘other activities’.
This stands for Earnings Before Interest Expense and Taxes.
Having underlined the importance and motive for which companies group their incomes and expenditures. It is important to observe and the level of profits that accrues to the company from each of their different forms of business activities.
EBIT is one of such measures. It specifically aims to identify the level of profits or losses that as company records purely from its trading activities without including government taxes or any other Financing activities (trading of equity, stock, debts, assets etc) of the company.
It basically aims to observe how profitable the main business endeavor has been at a particular period of time. In the case of a restaurant, EBIT aims to understand exactly how profitable it is to make and sell food & drinks at a particular time.
Components of EBIT
Interests refers to Income that the company earns from Financing Activities. It generally refers to the inflow of cash into the business through banks as loans, debts from creditors or equity from shareholders and outflow of cash to the shareholders in form of dividends, and debt servicing and interest payments out of a portion of the income generated from the business.
Taxes are the mandatory payments levied on a company the relevant government agencies in the jurisdiction within which it carries out its business activities.
EBIT is also called operating profit.
- How to Calculate EBIT
EBIT is obtained from a company’s Net Income by removing the effects of Interest expenses, Taxes paid. This can be achieved mathematically by adding back the figures deducted for Interests and Taxes to our Net Income or Operating Profit.
EBIT = Net Income + Interest Expense + Taxes paid.
Earnings Before Interest Expense, Taxes, Depreciation and Amortization
This measure takes EBIT one step further, and excludes the influence of Depreciation and Amortization from the profit figures of a company.
Components of EBITDA
Depreciation refers to the reduction in the monetary value or useful life of a company’s tangible assets. Assets of a company such as vehicles, machinery & equipment lose value and productivity as they are being used over time.
Amortization this is a similar concept of depreciation. The key difference is that it applies to intangible assets of the company. Such as licensing, leases, endorsements etc.
For example if an Oil & Gas company purchases a mining License valid for 10 years at $20 million. It typically means that it uses up $2million out of the value of the license annually.
This process of a periodical reduction in value of an intangible asset over time is what is known as amortization.
How to Calculate EBITDA
EBITDA = EBIT + Depreciation + Amortization
EBITDA is calculated mathematically by adding back the Depreciation and Amortization figures to EBIT.
This is another measure of profit that aims to express a company’s EBITDA (Operating Profit) as a percentage of its revenue. It shows the ability of a company to generate more income to fulfil its various obligations in the nearest future.
How to Calculate EBITDA MARGIN
EBITDA MARGIN = EBITDA / Revenue
What is a good EBITDA MARGIN?
When it comes to EBITDA Margin, the larger the better. A company is said to have good EBITDA Margin, when it has a relatively higher figure compared to its peers.
Reasons for Measuring EBITDA
EBITDA, like other various measures of profit are devised for diverse reasons.
Calculating EBITDA Shareholders to observe the viability and sustainability of a company’s business activities and trading methods.
- Employee appraisal
It helps the management appraise the performance of the various employees responsible for the different business units, departments or trading activities and reward them accordingly.
- Tax and Regulatory Requirements
Disclosing these figures is a means of accountability of the company’s management towards its financiers and the government. Companies are required to keep these records in order to aid tax agencies to make appropriate deductions that accrue to the government.
In fact, Publicly traded companies are required to publish their financials for the general public.
- Bankers Requirements
Bankers and creditors often require a certain level of profitability for in order to evaluate the eligibility of the company for loans and credit facilities.
- Potential Investors
EBITDA gives potential investors a clear picture of the financial strength and potential profitability of the company. If the figures are good it will help to attract more investors.