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My EBITDA is Bigger Than Yours . . .

Posted by Seth Elliott On September - 21 - 2010

Venture Capitalists, Investment Bankers and related professionals love to sprinkle their conversation with esoteric terms – most notably the fabled EBITDA and EBIT. Let’s examine the calculation of these items and, more importantly, why they are used.

EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. Although this can be calculated from the Net Income line, generally it is determined by taking Operating Income and adding back Depreciation and Amortization (which are part of SG&A).

EBIT is simply Earnings Before Interest and Taxes. In most cases, EBIT is equivalent to the Operating Income.

Occasionally, you may hear the term EBT – which stands for Earnings Before Taxes. In many cases, however, this is simply referred to as Pre-Tax Income.

There are a number of reasons that the terms EBITDA and EBIT are used regularly. These include:

For comparing firms. EBITDA and EBIT are simple mechanisms for highlighting “profitability” at various levels on the income statement. By using Gross Margin, EBITDA and EBIT and Net Income you can more readily compare firms to one another. The effects of intensive capital equipment investments (which result in depreciation and amortization), debt financing (which results in interest costs) and other capital structure differences mean that using Net Income as a comparison figure can be misleading. By examining these various components, a more appropriate financial picture emerges.

To showcase profitability. EBITDA and EBIT allow enterprises to highlight the profitability measure that is most favorable. For example, if your firm has a high debt load and (consequently) large interest charges when compared to others in your industry, you may choose to highlight EBIT instead of Net Income. Similarly, if you have a lot of capital equipment that results in high levels of depreciation, you may choose to highlight EBITDA.

As a valuation metric. Many financial professionals use EBITDA (or EBIT) as a baseline and apply a multiple to determine the enterprise value of the firm. This has become an accepted convention in the last 15 years. In our future examination of valuation, we will see that this method actually uses EBITDA (or EBIT) as a proxy for cash flow. Strictly speaking, valuations based on EBITDA multiples are lazy – but they have become so ubiquitous that the method itself is now a baseline for valuation determination.

To foster appearances of brilliance. At times, it seems that the purpose of EBITDA and EBIT is to make financial professionals seem brilliant and sophisticated. As a former (and perhaps reformed) finance professional, I can assure you that I am not entirely joking. Every profession has it’s jargon and the finance profession more so than most. By using terms like EBITDA and EBIT, investment bankers and venture capitalists create a patina of expertise that can discourage and intimidate entrepreneurs and serve to make the professionals appear smart and indispensable.

As you can see, measures of profitability like EBITDA and EBIT are not particularly complicated. As an entrepreneur, it is worth the time to gain an understanding of how these metrics are calculated. More importantly, it is helpful to understand how to deploy these methods to showcase your company’s financial results and to prepare you to “hold your own” in discussions with financial professionals.

In the next post in this series, we will examine further nuances of the Income Statement, including revenue recognition, accounting for inventories and depreciation.

You may wish to review other posts in this series, including:

Corporate Finance and the Entrepreneur

Leaping the GAAP

The Entrepreneur and the Income Statement

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About the Author

I have spent the last 15 years advising entrepreneurs on starting and growing their businesses, as well as assisting in financing those growth efforts. I have also been an entrepreneur on several occasions myself. By writing this blog, I hope to provide actionable advice on how to achieve your goals and become more successful.