What is EBITDA? A brief guide for small businesses

Banks use the EBITDA method to assess whether your business is able to pay off its debts.

If you approach a bank for a business loan or another form of finance, it will likely use EBITDA to determine whether your business is able to repay its debts.

This method of measuring a company first became popular in the 1980s, at the height of the leveraged buyout era.

Then, it was common for investors to financially restructure distressed companies (those that were unable to meet their financial obligations).

It was used mainly as a yardstick of whether a business could afford to pay back the interest associated with restructuring.

Read on to learn more about EBITDA in the modern day - what it is, how it's calculated and what it might mean for your business.

What does EBITDA mean? What does it stand for?

EBITDA (pronounced "ee-bit-dah") is a standard of measurement banks use to judge a business' performance.

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

To understand what each part of this means, see How to calculate EBITDA below.

As EBITDA doesn't account for the different ways a company may use debt, equity, cash or other sources to capital to finance itself, banks often use it to:

• compare two similar businesses
• understand a company's ability to generate cash flow.

How to calculate EBITDA

You can calculate EBITDA in two ways:

1. By adding depreciation and amortisation expenses to operating profit (EBIT)
2. By adding interest, tax, depreciation and amortisation expenses back on top of net profit

To use EBITDA, you need to understand what each part of this formula means.

Earnings

Normally, this is your net profit as you report it to HMRC.

Net profit is the total revenue you've generated from sales, minus the total amount you deduct as a legitimate business cost.

Before

The 'B' stands for 'before'.

The items below, when added to your net profit calculation, should change the amount of your net profit and your assets in your favour.

Interest

The interest you're charged when repaying your debt is added back to your earnings.

Taxes

EBITDA adds back taxes, which can vary from one period to the next and are affected by numerous conditions that may not relate directly to your business' operating results.

Depreciation

When you use tangible (physical) assets - such as machinery or vehicles - over time, they fall in value.

EBITDA adds back this loss in value.

Amortisation

This relates to the eventual expiring of intangible (non-physical) assets, such as patents or copyright.

In EBITDA, amortisation is added back.

What is the debt to EBITDA ratio?

A debt to EBITDA ratio measures a company's ability to pay off its debt.

A high ratio may indicate that the company's debt is too heavy a financial burden.

If your business were to borrow from a bank, the bank might include a debt to EBITDA ratio in the loan agreement.

This means you'd have to keep to the ratio set out in the agreement, or risk having to pay back the entire loan immediately.