In the world of acronyms, certain varieties roll off the tongue. For example, who doesn’t love saying OMG and ASAP? On the other hand, there are acronyms that seem like they were invented simply to make grown adults make silly toddler-like sounds. Of these ultra-awkward acronyms, EBITDA rules supreme.
Despite its clunky phonetics, we shouldn’t hate on EBITDA. It’s an important way to gauge your small business’s financial performance and profitability. What does EBITDA stand for? The answer is Earnings Before Interest, Taxes, Depreciation, and Amortization. And this metric represents your net income once you’ve put interest, taxes, depreciation, and amortization back into the mix.
So which is most important for your business in the battle of EBITDA vs. net income? First, it’s not a competition. Your business will always be healthier when your metrics play nice together and you can get a more complete picture of your finances.
EBITDA is great because it represents the strengths of your business and doesn’t put emphasis on factors that are out of your hands. The focus on profitability naturally makes it a prime tool when comparing your business to competitors within the industry. But this metric isn’t perfect, as it fails to provide a full view of your business finances. In some situations, you may find that it paints a rosier picture of your cash flow than what’s really happening due to the absence of capital investments.
Net income shows your business profit in a more progressed state than EBITDA. You start with your gross profit, then take out just your expenses and allowable deductions. What you’re left with is a metric that presents a clear view of your profitability.
The good news is that EBITDA formulas are among the most user-friendly of the various business metrics. You have 2 choices when it comes to EBITDA calculation, each based on a different origin.
If you want to start with your net income, here’s the EBITDA formula:
net profit + interest + taxes + depreciation and amortization = EBITDA
If you want to start with your operating income, here’s the EBITDA formula:
operating income + depreciation and amortization = EBITDA
The best calculation method to use depends on the unique details of your business and your goals for the metric. But as long as you already know your net profit and operating income, you’ll have options for how to proceed.
Some individuals in the financial world view the use of EBITDA with suspicion. This skepticism is because some businesses that have serious issues with their net income will attempt to mislead lenders or investors by showcasing inflated numbers derived through EBITDA calculation. It’s just a shame that such a helpful metric has been dragged through the mud by a few unscrupulous people.
But don’t be deterred by the actions of others. You should look at EBITDA as another important arrow in your quiver. If you were to rely solely upon this metric, you would never get an accurate view of your profitability. Using it in conjunction with other metrics, however, allows you to see finances from all angles.