EBITDA explained: What it means, how to calculate it, and why it matters for small businesses.

Every small business owner needs to be familiar with at least some financial terminology, and one term that’s especially important to understand is EBITDA.

“EBITDA is a metric that’s easy for small business owners to calculate and track regularly to make sure their business is financially healthy, because the figures you need to calculate it can be found on your balance sheet and income statement,” said Annastacia Bushman, senior underwriter in Commerce Bank’s Small Business Banking division.

Here’s what you need to know about EBITDA:

What is EBITDA?

The acronym EBITDA stands for “earnings before interest, taxes, depreciation and amortization.”

• Earnings: Your net income on your financial statement.
• Interest: The interest you’re charged when repaying debt.
• Taxes: Your federal, state and local income taxes.
• Depreciation: The loss in value of fixed (physical) assets such as computers, machinery and vehicles.
• Amortization: The loss in value of intangible assets such as patents, trademarks and software licenses.

EBITDA is a valuable financial metric for lenders because when you remove interest, taxes, depreciation and amortization from total earnings, you can get a clearer picture of a small business’s cash flow and make it easier to see how the business stacks up against competitors.

The EBITDA formula: Step-by-step calculations.

There are two ways for a small business to calculate EBITDA, depending on whether you start with your net income or operating income:

• Method 1: Net Income + interest + taxes + depreciation + amortization
• Method 2: Operating income (EBIT) + depreciation + amortization

Small business example of an EBITDA calculation:

• Net Profit: $175,000
• Interest expense: $15,000
• Taxes: $25,000
• Depreciation: $8,000
• Amortization: $4,000
• EBITDA: $227,000

EBITDA vs. operating income vs. net income: Key differences explained.

To understand your business’s financial health, it helps to know how net income, operating income and EBITDA differ, and what each of these figures reveals about the financial health of your company.

• Net income: Also known as net profit, a company’s net income represents its total earnings after subtracting all expenses, including taxes, interest and non-operating costs. It reflects the overall profitability of a business and is often called the “bottom line” because it appears at the bottom of an income statement.
• Operating income: This figure, also called operating profit, shows a company’s earnings from its main business activities before interest and taxes are deducted. It can give a clear picture of a company’s performance from its core activities and is useful for evaluating how efficiently day-to-day operations are running, before factoring in how a business is financed.
• EBITDA: This figure strips away costs that don’t affect a business’s cash flow. For small businesses, it’s a useful way to evaluate your cash-generating ability and operational performance independent of any taxes or debt.

Why lenders and investors care about your EBITDA.

For small business owners, EBITDA can help you understand whether or not your business is making money from your core operations. It’s also beneficial when comparing your business to others or evaluating investment or acquisition opportunities.

Lenders and investors will consider a small business’s EBITDA, along with other metrics, when deciding whether to invest in, or lend money to, the company.

“We use EBITDA to calculate a small business’s debt service coverage ratio, which helps us determine if a business generates enough income to pay back their debt payments every year,” said Bushman.

She said the Small Business Banking division typically looks at EBITDA plus the officer’s or owner’s salary versus EBITDA alone. “This is because small businesses are very closely tied to their owners, so if something happens with the owner, that’s going to adversely affect the business as well,” Bushman said.

EBITDA margin: Benchmarking your profitability.

Another profitability metric that lenders and investors consider when evaluating the financial health of a small business is EBITDA margin, which represents a company’s operating cash flow as a percentage of its total revenue.

EBITDA margin is calculated by dividing EBITDA by total revenue. For example, if a small business has a total revenue of $1.5 million and an EBITDA of $227,000, its EBITDA margin would be 15%.

EBITDA margins can vary, depending on the type of small business you operate, but a healthy margin for a small business is roughly 10% to 20%. Another indicator of a small business’s financial health is that its EBITDA margin is consistent or improves over time.

Comparing your margin to industry averages can be beneficial because it highlights areas where you might be able to improve costs or pricing.

How a small business can improve its EBITDA.

There are several steps that companies can take to improve their operational efficiencies and the overall financial health of a company.

Managing cash flow and liquidity is a key component. Accurate forecasting, identifying possible shortfalls, and looking for opportunities to reduce accounts receivable balances can help you plan for having enough accessible funds to cover daily operations without jeopardizing long-term financial stability.

Improving your invoice management and payments scheduling systems can also help you avoid late fees and unnecessary interest costs. You can also review fixed versus variable costs, and identify expenses that can be adjusted.

Beyond EBITDA: Other factors that lenders consider.

When evaluating the financial health of a small business, lenders will usually look at several other factors in addition to EBITDA.

“We’re looking at sales trends, year over year, and whether they’re increasing or decreasing,” Bushman said. “If they are decreasing, we want to know that a company has a good plan in place to reverse any downward trends they might be seeing, such as diversifying either its customer base or its products and services.”

Lenders also look at any unexpected large expenses that a business incurs, and how the company is planning for any future expenses.

“Small businesses should also be paying attention to outside factors that might be affecting their industry, such as tariffs, and have a plan in place,” said Bushman. “It’s important to understand both the broader macroeconomic environment and what’s happening in your industry as a whole.”