What is EBITDA and how can it help you measure business profitability?

What is EBITDA?

First, what is EBITDA? EBITDA stands for “earnings before interest, taxes, depreciation, and amortization." Easy to see why it's shortened to an acronym, right?

At its core, EBITDA measures a company's operating profitability, stripping out non-operating expenses. For business owners, this means you get a clear view of how much your company is actually earning from its operations without outside financial factors skewing the results.

Let’s explore an EBITDA example. Say you’re running a profitable company but have taken out loans to expand. Even though your net income looks low after accounting for interest payments, your EBITDA shows strong operating profitability. This makes it easy to demonstrate your business’s earning potential to investors or lenders — without your financing decisions making the numbers look worse than they really are.

Components of EBITDA

To truly understand the answer to “What is EBITDA?”, you need to know the key financial elements it is made up of. Let’s break them down:

• Net income: The company’s business net income after all expenses, including operating costs, interest, and taxes.
• Interest: Interest paid on business loans or lines of credit, such as real estate or equipment loans.
• Business taxes: Federal, state, or local income taxes paid by your business. Since tax structures vary, EBITDA does not factor them in.
• Depreciation: The amount by which the value of tangible business assets (such as vehicles or buildings) decreases over time.
• Amortization: The amount by which the value of intangible business assets (such as patents or trademarks) decreases over time.

How to calculate EBITDA

The EBITDA formula is the following:

EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization¹

Here's an example of how a business can use this formula:

1. Determine net income: A company generated $200,000 in annual revenue. They spent $50,000 on operating and non-operating expenses. That leaves a net income of $150,000. (How to determine net income? Subtract total expenses from total revenue: $200,000 - $50,000 = $150,000.)
2. Add interest: The company paid $4,000 in interest expenses, such as for a small business loan.
3. Add taxes: The company paid $3,000 in combined federal, state, and local taxes.
4. Add depreciation and amortization: The value of the company's tangible and intangible assets decreased by $9,000 over the year due to depreciation and amortization.
5. Calculate EBITDA: Now, apply the EBITDA formula. EBITDA = $150,000 + $4,000 + $3,000 + $9,000 = $166,000.

At first glance, it might seem contradictory that EBITDA "ignores" taxes and interest, yet we add them back into the formula. That’s because net income already includes interest and taxes, which are calculated after all expenses have been deducted.

To determine EBITDA, we reverse this by adding them back, effectively stripping away the impact of financing decisions and tax obligations. This allows EBITDA to focus solely on operating profitability, giving a clear view of how much a business earns from its core operations.

Advantages of using EBITDA

Why use EBITDA? For growing businesses — especially startups and those seeking funding — it can mean the difference between piquing investor interest and getting lost in the noise.

Calculating your EBITDA can help:

• Uncover the fair value of businesses: Numbers matter, but so does how they’re presented. EBITDA offers a clear look at the value of a business, filtering out taxes and interest so buyers and investors can focus on its earning potential. It’s especially helpful when pitching to venture capitalists or private equity firms.
• Compare businesses: No two companies are structured the same. One might carry heavy debt, while another gets tax breaks. EBITDA removes those differences, making it a go-to metric for comparing operating performance across businesses in the same industry.
• Understand cash profitability: A business might look unprofitable on paper due to tax strategies or financing decisions, but EBITDA helps reveal a company’s core profitability before these financing and tax burdens come into play. That’s a big deal for investors looking for sustainable growth.
• Attract buyers and investors: When potential investors evaluate a company, they don’t want to sift through complex financial statements. EBITDA simplifies things, providing a clean, easy-to-digest number that signals financial health. A strong EBITDA can make your business more appealing to buyers and funding sources.

Limitations of EBITDA

EBITDA is a useful tool, but relying solely on it for financial analysis can be misleading. While it can provide a foundational understanding of business profits, it may not represent a company's true financial health. A business can report a strong EBITDA while struggling with high debt or cash flow issues — things that investors and lenders care about just as much.

Specifically, EBITDA:

• Ignores debt and interest payments: EBITDA excludes interest expenses, which means a company with a high EBITDA could still be drowning in debt. In other words, a business with substantial loans and high-interest payments might look profitable on paper but struggle to stay afloat in reality.
• Doesn’t factor in taxes: Taxes are a real expense, and EBITDA leaves them out of the equation. Since tax obligations vary widely based on location and structure, a company’s financial health might look better under EBITDA than it actually is when taxes come due.
• Overlooks capital expenditures: Businesses with large assets (like manufacturing companies) need to reinvest in equipment, facilities, and technology. EBITDA doesn’t account for these expenses, which can lead to an overly optimistic view of profitability.

EBITDA vs. net income

When it comes to measuring profitability, EBITDA and net income tell two very different stories. So, what's the difference between EBITDA and net income?

Net income is a calculation of your total earnings after paying all expenses — operating costs, interest, taxes, depreciation, and amortization. Because it includes every financial factor, net income gives a full view of a company’s financial health and plays a direct role in determining tax obligations. If a company has high revenue but a disappointingly low net income, it might be overspending or struggling with debt.

On the other hand, EBITDA is a calculation of your earnings after paying only operating expenses. That means it ignores financing decisions and tax burdens, making it a popular metric for comparing companies across industries. Investors often use EBITDA to gauge whether a business is generating strong profits from its core operations. But since it doesn’t account for major expenses, relying on EBITDA alone can paint an overly rosy picture.

So, EBITDA vs. net income — which one matters more? That depends on what you’re looking for. Net income tells the full financial story, while EBITDA focuses on pure operational performance. Smart businesses and investors use both to get a well-rounded view of profitability.