Several key metrics can help you understand and manage your business’s financial performance. EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortisation, is one of these essential tools.
However, many business owners struggle to grasp what EBITDA is and how it can be used to improve profitability.
In this article, we will take a detailed look at EBITDA, explaining what it is, how to calculate it, and why it’s crucial for small businesses. By the end of this guide, you’ll be equipped with the knowledge to leverage EBITDA for better financial decision-making.
Table of Contents
What is EBITDA?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortisation. It is a financial metric that you can use to assess your company’s profitability by excluding non-operational expenses such as interest payments, taxes, and the costs associated with asset depreciation and amortisation.
Unlike net profit, which includes these expenses, EBITDA provides a clearer picture of your business’s operational efficiency. It also differs from operating profit by adding back depreciation and amortisation, offering a more comprehensive view of core business performance.
EBITDA can be a valuable tool for understanding the current value of your business and assessing its financial health. It can also help investors and lenders evaluate your company’s ability to generate cash from its core operations, making it a crucial metric for attracting investment and securing loans.
Why small businesses should care about EBITDA
If you are a small business owner, EBITDA is particularly useful as it helps attract investors and lenders by demonstrating operational profitability.
It can also help you compare your business’s performance with industry peers, as it strips away differences in financing and accounting practices. This comparability is essential for understanding how well a business is performing relative to its competitors.
How to calculate EBITDA
To calculate EBITDA, you need to essentially add interest, taxes, depreciation, and amortisation back to your profits. This helps you understand what your company brings in overall without accounting for many of its expenses.
Here is the standard EBITDA formula:
EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortisation
Let’s take a closer look at each component.
- Net Profit: The total earnings after deducting all expenses
- Interest: The cost of borrowing money, such as bank loans
- Taxes: Income taxes paid to the government
- Depreciation: The decrease in the value of tangible assets like equipment or vehicles over time
- Amortisation: The decrease in the value of intangible assets like patents or trademarks
Example EBITDA calculation
Let’s consider a small Australian business with the following financial figures:
- Net Profit: $100,000
- Interest expenses: $20,000
- Taxes: $30,000
- Depreciation: $40,000
- Amortisation: $10,000
EBITDA = $100,000 + $20,000 + $30,000 + $40,000 + $10,000 = $200,000
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Adjustments to EBITDA (Normalised EBITDA)
Sometimes, businesses adjust EBITDA to exclude one-time expenses or non-recurring items, such as an owner’s salary or unusual legal fees, in order to provide a more accurate representation of their financial performance. This normalised EBITDA provides a clearer picture of ongoing operational performance.
Here are some key reasons and examples for making these adjustments.
- Exclusion of non-recurring items: Removing costs that do not reflect the company’s ongoing operations, such as:
- Unusual legal fees
- One-time restructuring costs
- Non-recurring gains or losses from asset sales
- Adjustments for owner-related expenses: Adjusting for items like an owner’s salary, which may not be reflective of standard operational costs
- Normalisation for comparison purposes: Ensuring that EBITDA figures are comparable across different companies or time periods by standardising the financial presentation
Typically, these adjustments are made when presenting financials to investors or during business valuations to ensure that the EBITDA figure accurately reflects the company’s sustainable profitability.
By normalising EBITDA, you can provide stakeholders with a more accurate view of their operational efficiency and potential for future growth.
EBITDA vs other financial metrics: How does it compare?
In practice, EBITDA serves as a powerful tool for investors and analysts seeking to evaluate a company’s core operational performance, free from the influence of external factors such as debt or tax environments. For instance, when comparing two companies with different capital structures or operating in different tax jurisdictions, EBITDA provides a more level playing field.
On the other hand, you have the option of calculating net profits, EBIT, and gross profits, the pros and cons of which we’ve summarised in the table below.
| Metric | Description | Pros and Cons |
| EBITDA | Excludes interest, taxes, depreciation, and amortisation | Useful for comparing operational efficiency across companies; ignores capital expenditures and debt obligations |
| Net Profit | Includes all expenses, providing a comprehensive view of profitability | Reflects overall profitability but can be influenced by financing and accounting decisions |
| EBIT | Excludes taxes but includes depreciation and amortisation | Provides a view of profitability before taxes but still accounts for asset depreciation |
| Gross Profit | Excludes operating expenses but includes depreciation and amortisation | Focuses on product profitability but doesn’t account for operational costs |
EBITDA vs net profit
Net profit, also known as net income, is the final profit after deducting all expenses, including non-operating expenses like interest and taxes. It offers a comprehensive view of overall profitability and is crucial for assessing your company’s financial health and potential for growth.
Internally, you might use net profit internally for strategic decisions and externally, investors might look at net profit to evaluate your company’s efficiency and profitability. However, it can be influenced by financing strategies and accounting practices, making it less ideal for cross-company comparisons.
EBITDA vs EBIT
EBIT stands for Earnings Before Interest and Taxes. This metric provides insights into profitability before taxes but still accounts for asset depreciation and amortisation.
EBIT is particularly useful for businesses with significant tangible assets, as it helps evaluate operational performance while considering the impact of asset depreciation. The metric is also valuable for assessing a company’s ability to service its debt obligations, as it is used in calculating the interest coverage ratio.
EBITDA vs gross profit
Gross profit focuses on product profitability by subtracting the cost of goods sold (COGS) from revenue. It is ideal for evaluating production efficiency and identifying opportunities to improve profit margins by optimising production costs.
Ultimately, a combination of these metrics provides a more complete picture of a company’s financial health and operational efficiency.
Limitations of EBITDA for small businesses
While EBITDA offers valuable insights into operational profitability, it has several limitations that you need to be aware of. These limitations can affect how accurately EBITDA reflects your company’s overall financial health.
Ignores capital expenditures
EBITDA does not account for the cost of replacing or upgrading assets, which can be significant for businesses with high capital requirements. This oversight can lead to an overly optimistic view of a company’s financial situation if it requires substantial investments in new equipment or infrastructure.
Debt obligations
By excluding interest payments, EBITDA does not reflect a company’s financial leverage or debt servicing capabilities. This can be misleading for businesses with high levels of debt, as it does not account for the financial strain of servicing these obligations.
Non-cash items
EBITDA includes depreciation and amortisation as non-cash items, which can distort cash flow perceptions. While these are not actual cash outlays, they represent real economic costs that affect a company’s ability to invest in growth or service debt.
As a result, EBITDA might not be the best metric if your business:
- Has significant capital expenditures
- Relies heavily on debt financing
- Is undergoing substantial asset depreciation
In these cases, other metrics like cash flow or net profit might provide a more comprehensive view of financial health.
How small businesses can use EBITDA to improve profitability
Your businesses can leverage EBITDA to track profitability trends over time and benchmark against industry standards. This can help identify areas for improvement and measure your performance relative to competitors.
Here are some strategies you can implement to enhance your EBITDA.
1. Reduce operational costs
Focus on streamlining operations to minimise unnecessary expenses. To do so, you can use the following strategies.
- Conduct regular expense reviews: Identify and eliminate unnecessary services or consolidate suppliers to reduce costs.
- Optimise processes: Automate manual processes and eliminate inefficiencies to improve operational efficiency.
2. Increase revenue
Implement strategies to boost sales.
- Expand your product lines: Introduce new products or services to attract more customers.
- Improving marketing efforts: Enhance marketing campaigns to increase brand visibility and attract new customers.
3. Optimise asset utilisation
Ensure that assets are used efficiently to minimise depreciation costs.
- Implement predictive maintenance: Use data analytics to predict and prevent equipment failures, reducing downtime and maintenance costs.
- Monitor asset utilisation: Ensure all assets are operating at their full potential to avoid inefficiencies.
4. Improve inventory management
Effective inventory management can significantly impact EBITDA by reducing carrying costs and minimising stockouts.
- Adopt inventory management software: Accurately track stock levels and demand trends to optimise inventory levels.
- Implement Just-in-Time (JIT) inventory systems: Receive supplies only when needed to reduce storage costs and waste.
5. Leverage tax credits and incentives
Maximise available tax credits and government incentives to reduce expenses and boost profitability
- Work with a tax advisor: Identify applicable credits such as R&D tax credits or incentives for sustainable practices.
- Ensure compliance: Avoid penalties by adhering to local tax laws.
FAQ
What is a good EBITDA margin for a small business?
A good EBITDA margin varies by industry, but generally, a higher margin indicates better operational efficiency. Here are some typical ranges by industry:
- Retail: EBITDA margins typically range from 2% to 5%. This is due to thin profit margins and high operational costs associated with inventory management and store operations.
- Software and technology: These industries often have higher EBITDA margins, typically between 25% and 40%. This is due to scalable business models, low variable costs, and recurring revenue streams.
- Healthcare: EBITDA margins in healthcare generally fall between 15% and 25%.
- Consumer staples: Companies in this sector usually have EBITDA margins of around 10% to 15%. This reflects the balance between operational efficiency and the need to maintain competitive pricing in consumer markets.
- Manufacturing: EBITDA margins in manufacturing can vary widely but generally range from 10% to 20%. This variability depends on factors like production costs, economies of scale, and market demand.
Can EBITDA be negative? What does it mean?
Yes, EBITDA can be negative if operational costs exceed revenue. This indicates poor operational efficiency and may signal underlying financial issues.
Using EBITDA to your advantage
In conclusion, EBITDA is a powerful tool for small businesses in Australia, offering insights into operational profitability and helping attract investors. By understanding how to calculate and use EBITDA effectively, you can make informed decisions to improve your business’s financial health.
Need help with managing your business’s finances while ensuring full compliance with Australian laws and regulations? Look no further than Lawpath. Work with our team of experts to navigate toward business success.
