Explaining EBITDA to Clients

EBITDA can sound like a strange acronym to your clients, and they may wonder, “Why another calculation? What about all the other metrics? Aren’t they enough?” However, Pennsylvania businesses will benefit when their accountants and CPAs can explain the importance of this measurement and help them leverage it to make beneficial business decisions.

EBITDA, the acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization, is easily calculated. 

EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization 

EBITDA measures operating profits as a percentage of revenue, which allows business owners, investors, and potential buyers to focus on the effect of operating decisions on profitability without the impact of non-operational management decisions and taxes. While these other expenses are critically important for a company to measure, a clearer view of profits from operations can be measured by removing them.

Of course, in order to come to an accurate valuation, income and expenditures must be carefully recorded. If your client has not invested in a robust accounting program and created strict procedures for tracking what comes in and goes out of the company, none of the financials will be accurate, leading to poor management decisions and lost revenue. This would be a good opportunity to discuss with the company about evaluating and strengthening their bookkeeping.

How to use EBITDA

EBITDA can provide valuable information for multiple purposes:

• EBITDA helps those interested in buying or selling communicate the health of business operations. A good EBITDA makes a business more valuable to investors as well as creditors.
• EBITDA can be used to compare the health of a business in relation to other companies in the industry.
• EBITDA provides executives and owners with important information about operational efficiency to aid in strategic planning.
• EBITDA is used as a basis for other calculations. For instance, EBITDA Margin measures operating profit as a percentage of revenue.

EBITDA Margin = EBITDA/total revenue * 100

A higher EBITDA margin indicates lower operating expenses in relation to total revenue, and thus better company performance. Using this calculation, two companies in the same industry can be compared by the EBITDA Margin, even when their revenue is quite different, to indicate which may be the healthier company and thus a better investment.

For instance:

1. Company A -  has an EBITDA of $100,000 and revenue of $1,000,000. Its margin is 10.0%.
2. Company B -  has an EBITDA of $150,000 and revenue of $2,000,000. Its margin is 7.5%.

This comparison helps investors, creditors, and business leaders compare both companies on the same merits, so while Company A has lower revenue, it is financially stronger than Company B.

EBITDA Coverage Ratio is essentially a test of solvency against liabilities associated with leases and debts. It is calculated:

EBITDA Coverage Ratio = (EBITDA + lease payments) / (interest payments + principal payments + + lease payments)* 

*A result over 1.0 indicates the company is in a solid position to pay off liabilities and debts.

Adjusting EBITDA

There are many ways to adjust EBITDA in order to help your business clients discover nuanced information about the strengths and weaknesses of their company. It’s important, when using any adjusted EBITDA calculations, that adjustments are clearly stated and completely transparent, so there is no risk of misleading possible investors or buyers.

Adjusting EBITDA can be a good idea to show business executives the effects of certain one-time or unique payments, or any expenses that are in question. For instance, a one-time, non-recurring expense may skew profitability in a given year. Removing that expense may give a more accurate picture. 

Single-time loss or gain on investments, litigation expenses, donations, asset write-downs, or a large retirement package might be removed to keep a clear picture of operational profits. 

As your client’s financial expert, you can advise the business leadership when there are unusual expenses or earnings in a given year that might skew results. Help your clients get the most accurate picture of their company’s financial strength to help them make the right decisions to grow into the future.