What Is EBITDA and Why Is It Important to Understand?

If you spend enough time around accountants, lenders, investors, or business buyers, eventually you’re going to hear the term EBITDA.

It sounds complicated. It really isn’t.

Even if you never plan to sell your business or raise outside capital, EBITDA can be a useful number for understanding how your business is actually performing.

Let’s unpack it.

What Does EBITDA Mean?

EBITDA stands for:

Earnings Before Interest, Taxes, Depreciation, and Amortization.

In simple terms, EBITDA is a way of looking at the earnings generated by your business before several expenses that can make comparisons between businesses more difficult.

Think of it as another lens for looking at profitability.

Your net profit tells you what is left after essentially everything has been accounted for.

EBITDA backs out four categories:

Interest: The cost of borrowing money.

Taxes: Income taxes owed based on your business structure and tax situation.

Depreciation: An accounting expense that recognizes the declining value of physical assets over time.

Amortization: Similar to depreciation, but generally associated with intangible assets.

By removing those items, EBITDA can help you focus more closely on the earnings produced by the underlying operations of the business.

A Simple EBITDA Example

Imagine your business generates:

$1,000,000 in annual revenue

After all expenses, your income statement shows:

$100,000 in net income

During the year, you also recorded:

• $25,000 of interest expense

• $30,000 of income taxes

• $35,000 of depreciation

• $10,000 of amortization

Your EBITDA would be:

$100,000 + $25,000 + $30,000 + $35,000 + $10,000 = $200,000

So while the business produced $100,000 in net income, it generated $200,000 in EBITDA.

Neither number is necessarily more correct.

They simply answer different questions.

Why Do Business Owners Care About EBITDA?

One of the biggest advantages of EBITDA is that it can make it easier to evaluate the performance of the business itself.

Consider two otherwise similar businesses.

One owner purchased equipment with cash.

The other financed the same equipment and has significant interest expense.

Their financing decisions could cause their bottom line profits to look very different even if the underlying businesses perform similarly.

Taxes can create similar differences. So can depreciation.

EBITDA attempts to remove some of those variables so you can better evaluate the operating earnings of the businesses.

That makes it particularly useful when comparing performance across different companies, locations, or periods.

EBITDA Can Become Especially Important When You Sell a Business

For many owners, EBITDA becomes much more important when they begin thinking about the value of their company.

Business valuations are often discussed using an EBITDA multiple.

For example, imagine a business produces $500,000 of EBITDA and similar companies are selling for approximately 5× EBITDA.

A simplified valuation might look like:

$500,000 × 5 = $2,500,000

Actual business valuations are considerably more complicated. Industry, growth rate, customer concentration, recurring revenue, margins, management structure, risk, debt, and many other factors can affect what someone is willing to pay.

But this illustrates why an owner preparing to sell a business may suddenly hear a lot about EBITDA.

Increasing EBITDA can potentially have a multiplied effect on the value of the company.

If that same business increased EBITDA from $500,000 to $600,000 while maintaining a 5× valuation multiple, the simplified valuation would increase from:

$2.5 million to $3 million.

A $100,000 improvement in annual EBITDA could represent a $500,000 difference in enterprise value in that example.

That is why understanding EBITDA several years before selling a business can be so valuable.

EBITDA Margin Matters Too

The dollar amount is not the only number worth understanding.

You can also calculate your EBITDA margin:

EBITDA ÷ Revenue × 100

If your company generates $1,000,000 in revenue and $200,000 in EBITDA:

$200,000 ÷ $1,000,000 = 20% EBITDA margin

This tells you that approximately 20 cents of EBITDA is being generated for every dollar of revenue.

Tracking the margin can be especially useful as your company grows.

Suppose revenue increases from $1 million to $1.5 million.

That sounds great.

But what happened to EBITDA?

If EBITDA barely changed because expenses increased almost as quickly as revenue, your business may not be scaling as efficiently as the revenue number suggests.

Revenue tells you how much you are selling.

EBITDA can help tell you how much of that growth is actually translating into earnings.

EBITDA Is Not the Same as Cash Flow

This is an important distinction.

EBITDA is not cash in the bank.

A company can have strong EBITDA and still struggle with cash flow.

Why?

Because EBITDA does not fully account for things such as:

• Principal payments on debt

• Purchases of equipment or other capital expenditures

• Changes in inventory

• Customers who have not paid their invoices yet

• Other working capital needs

You could have a profitable business on paper while still wondering why the checking account feels painfully empty.

That is exactly why no single financial metric should be viewed in isolation.

EBITDA is one piece of the financial picture. It is not the entire picture.

What Is Adjusted EBITDA?

If you ever discuss selling a business, you may also hear the term Adjusted EBITDA.

Adjusted EBITDA attempts to account for expenses or income that may not represent the normal ongoing operation of the business.

For example, a business might have incurred a large one time legal expense that is not expected to occur again.

A potential buyer might adjust EBITDA to remove that expense when evaluating the company’s normalized earnings.

Owner operated businesses can sometimes have additional adjustments related to owner compensation, personal expenses running through the business, or other unusual items.

But adjustments should be reasonable and supportable.

Calling every expense you do not like a “one time expense” does not magically increase the economic performance of your business.

A sophisticated buyer, lender, or advisor is going to examine those adjustments.

Is EBITDA the Most Important Number in Your Business?

No.

And that is actually the point.

There probably is not one number that tells you everything you need to know about your business.

Revenue matters.

Gross profit matters.

Net profit matters.

Cash flow matters.

Your balance sheet matters.

EBITDA matters.

The goal is not to find one magical financial metric.

The goal is to understand what each number tells you and what it does not.

The Bigger Lesson

You do not need to become an accountant to understand your business.

But you should understand the numbers that help explain how your business is performing.

EBITDA can help you evaluate operating performance, compare results over time, understand how efficiently your company is growing, and prepare for conversations with lenders, investors, advisors, or potential buyers.

If you eventually plan to sell your company, understanding EBITDA years before that conversation begins can also give you more time to understand what drives it and identify opportunities to improve it.

The goal is not to become an expert in every financial calculation.

The goal is to understand what your numbers are telling you about your business.

Unpack Your Business Numbers

UnpackFi is designed to help business owners understand how EBITDA, revenue, expenses, margins, profitability, cash flow, and other financial information work together.

EBITDA should not just be another number on a financial report. Understanding what is driving it can give you a clearer picture of how your business is performing and how that performance is changing over time.

Try the free UnpackFi demo at UnpackFi.com and see your business numbers in a more visual, practical way.