What is EBITDA? A short guide for small businesses

Small to medium businesses account for over 99% of the UK business population, yet, an average of 1 in 5 new businesses fail in their first year. With such a high rate of new business failures, and SMEs playing such an essential role in the economy, it’s vital for small businesses to get a firm grasp on their financial health.

There are a variety of popular measurements to help businesses understand their profitability, one of which is EBITDA. Here’s what EBITDA is and how it can impact your business.

What is EBITDA?

EBITDA stands for earnings before interest, taxes, depreciation, and amortisation.

Let’s break that down a little:

Earnings

Earnings are how much your company makes. Essentially, it’s your profits as a number. In this case, we’re referring to your earnings before the following expenses.

Interest

Interest is how much you pay on debt. Let’s say you have a working capital loan in the amount of £5,000, and you pay 5% interest on the loan, amounting to £250. The £250 would be your interest. If your earnings (profits) amount to £9,750 after you subtract this interest from your ledger, then your EBITDA earnings would be £10,000.

Taxes

If you’re a small to medium UK based business, the taxes portion of EBITDA stands for corporation tax.

Depreciation

Depreciation is how much your assets depreciate in value over time. For instance, let’s say you purchase a fleet of Range Rovers for your company, over time, that fleet would decrease in value, reducing the value of your assets as a company.

Amortisation

Amortisation is very similar to depreciation, but refers specifically to intangible assets, like purchased software products or owned copyrights.

By calculating profitability before these common company expenses, EBITDA aims to provide a picture of your company’s financial performance.

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How is EBITDA used?

Banks, acquiring companies and business owners all use EBITDA to assess a company’s profitability.

The positives of EBITDA

Financial decisions and accounting processes vary by company, and EBITDA provides a means to measure and assess profitability, and therefore sales, marketing, and operations activities, without these financial costs factored in. This can help your business gain a more complete understanding of the success of your activities.

If, for example, your company is heavily burdened with loans and depreciating assets, it’s possible you could look at your company profits and feel unmotivated, or, you could look at your cash flow reports and feel as though your hard work isn’t paying off. But by assessing the success of your business with EBITDA, this enables you to understand that your sales and operational efforts are paying off, it’s just that you need some more strategic financial management.

EBITDA could help you realise that to achieve financial success as a whole, you need to renegotiate the interest on your loans, evaluate your asset portfolio, and look at other possible financing options, for example, perhaps leasing company vehicles might suit you better than purchasing them.

EBITDA drawbacks

Despite its wide use, EBITDA is not without its critics. From Warren Buffett to certain accounting bodies, EBITDA has been critiqued for its tendency to overlook essential aspects of running a business.

By ignoring or setting aside critical costs to businesses, some say EBITDA provides an incomplete picture of a company’s finances. Some even go so far as to call it misleading. In fact, the SEC, a regulatory body in the USA that works to protect investors, has banned listed companies from reporting EBITDA per share.

By not accounting for financial management costs, EBITDA may not realistically display the actual profitability of companies, as these costs can eat into that profitability dramatically.

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Should I use EBITDA to measure my company’s performance?

Only you can truly say if EBITDA can benefit your company. However, here are some thoughts to consider.

For starters, measuring your company's profitability and success is a fantastic way to strategise and reflect. There are many different ways to measure company performance, and each has its own pros and cons and place in your strategy.

EBITDA can be used to track your operational efficiency, compare your company to others when evaluating performance based on operations, and set performance goals. It can also be used to negotiate with lenders and investors, as it can help demonstrate your company's ability to turn a profit.

Finally, you could also use EBITDA to assess the impact debt is having on your business. For instance, if your general profitability is very low, but your EBITDA is very high, this could indicate that your company is overburdened by debt and you may need to focus on reducing debt in the future.

When using EBITDA, be careful to balance it out with cash flow reports and other company performance metrics to prevent you from accidentally viewing your company as more profitable than it really is.

How do I calculate EBITDA?

Get your current net profit number. Then, add on your corporation tax, interest payments, amortisation and depreciation expenses to that number. Or in other words:

Revenue - expenses = net profit

Net profit + corporation tax + interest payments + depreciation and amortisation expenses = EBITDA

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Please note that the information above is not intended to be financial advice. You should seek independent financial advice before making any decisions about your financial future.

It’s important to remember that all loans and credit agreements come with risks. These risks include non-payment and late-payment of the agreed repayment plan, which could affect your business credit score and impact your ability to find future funding. Always read the terms and conditions of every loan or credit agreement before you proceed. Contact us for support if you ever face difficulties making your repayments.

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