Stick around the business world long enough and you’ll hear people talk about EBITDA. And by long enough, I mean two minutes or so. But I’m here to tell you that EBITDA is a made up, crap financial metric for most small businesses. There are very few use cases for when EBITDA is actually useful for small businesses, and we will talk about them shortly.
What is EBITDA?
EBITDA is an acronym that stands for “Earnings Before Interest, Taxes, Depreciation, and Amortization.” EBITDA is generally used in finance to measure a company’s cash flow from operations:
- Interest is for carrying cost of debt
- Depreciation and Amortization are non-cash expenses related to the use of the property, both tangible and intangible assets.
- Income Taxes can vary by jurisdiction and are typically outside the control of the company (because you know Congress). Other taxes, such as payroll and sales taxes, are included in the EBITDA calculation.
How do you calculate EBITDA?
Calculating EBITDA is pretty straight forward. From your income statement (or profit and loss statement), take your net income and add back the interest, taxes, depreciation, and amortization.
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
Remember, we only add back the income taxes and not other taxes (payroll, sales, property, etc) that a company may pay or be liable for.
Why EBITDA is Crap
For most small businesses, EBITDA is a horrible financial metric for business owners to get in the habit of using. See, it ignores the very real cash need of paying taxes.
If you think you are profitable or have a healthy business because your EBITDA is positive or even growing, you may still have a major headache when it comes time to pay your taxes. Because that could be a major hit on your cash flow.
Similarly, interest and repayment of debt has a big impact on your day-to-day business operations. This is more true right now than it has ever been, with the higher interest rates and sometimes uncertain business outlooks for many of us. If you’ve been measuring the health of your business ignoring interest, you may very well end up out of business when your creditors come calling.
What about Depreciation and Amortization?
Meanwhile, depreciation and amortization may not impact the cash flow of your company like taxes and interest. But they are still very important aspects of what is going on in your business.
Let’s say you buy a delivery truck for your company. That’s a big cash hit to your bank account when you pay in full in cash. But the good news is that you have an asset that will serve you over many years, letting you deliver your product to stores in your area. That’s why those big purchases don’t end up on your income statement but do go towards your balance sheet (reduce cash, increase property in double entry accounting speak).
Which is why in accounting we spread the value of that purchase out over several years, specifically the “useful life” of the asset. This lets you spread the expense out over the years when you’ll be using the asset to make money – so it’s a better reflection of the true cost of your revenue.
So by ignoring depreciation and amortization when you use EBITDA as a metric, you ignore the fact that you have to buy the asset in the first place. Back to the example of the delivery truck – without it, you cannot move your product from your store to your customer. And that means that you won’t have those earnings because the sale won’t happen.
Bottom Line: EBITDA Overstates Profits
Because EBITDA only adds back line items, it has the end result of always inflating the company’s earnings. Many companies and business owners also get “creative” in how they calculate EBITDA to protect their own ego or to hide bad news from investors or other stakeholders.
This means that you will be making bad decisions on the health of your company, especially if you use it in day-to-day financial management of your company.
When is EBITDA Useful?
EBITDA can be useful in very limited circumstances.
- One of those is when you are buying companies and you are trying to compare potential acquisitions. You know that taxes are dependent on different locations and even sometimes who has the better accountants and lawyers (and you think you have the best of each). You may also be paying off most, if not all, of the pre-existing long-term debt of the company that you do end up buying. But you will be interested in the cash flow from the company, so you ignore the non-cash depreciation and amortization.
Having a common metric to compare across multiple companies to see which is the better deal can be very useful. This is where EBITDA is most useful.
- The second useful situation is when you are managing portfolio risk. This is really important for bankers or private equity companies that want to make sure that you have enough cash from your operations to pay them back for the loans or investments that they have made or will make to you. Again, ignoring the non-cash depreciation and amortization is useful. Interest can often be ignored because you could be re-financing other long-term debt or providing the cash to pay taxes.
Leveraged Buyouts and Other EBITDA History
EBITDA first came about from John Malone, a billionaire investor that got rich buying cable TV systems and figuring out how to game the tax system. Already, you can probably see how the financial metrics that a billionaire uses probably aren’t going to be awesome for routine management of a small business. I mean, wouldn’t we all love to just ignore taxes in our businesses?
As Malone became successful through the 1970s, other investors started following his lead. They began focusing on EBITDA too. When the leveraged buyout craze hit in the 1980s, EBITDA was a great metric for investors to determine if the company would have the cash flow necessary to service the acquisition debt. EBITDA wasn’t about management – it was about servicing the debt.
If EBITDA is Crap, Why Do We Hear So Much About It?
Honestly, we hear about it so much because of Finance Bros in certain industries like technology and software. Think about who gets the most press or coverage in the business books…
Finance Bro 🤝 Tech Bro
EBITDA 💓 Forever
It’s the companies getting bought and sold with the big publicity push that happens after a transaction. The business press will talk about things like “multiples” and “EBITDA” and now all of a sudden you think you need to talk about it too. And even better when it is a flashy Tech Bro.
Even the SEC Agrees
The U.S. Securities and Exchange Commission (SEC), the federal agency that oversees much of the financial reporting on publicly traded companies (among other things), even agrees that EBITDA has limited usefulness. The SEC requires that companies reporting EBITDA to also disclose exactly how they calculate the figure and bars companies from reporting EBITDA on a per-share basis.
Earnings per share is a widely used metric to compare how companies are doing, especially over time. Since EBITDA inflates the profitability of a company by ignoring these very real costs, the SEC wants to limit the use of the metric.
EBITDA Makes Warren Buffett Shudder
Warren Buffett is on record as saying that he agrees with me, that EBITDA is crap. OK, that’s not the words he uses. However, the sentiment remains the same.
In the 2000 Annual Report for Berkshire Hathaway, he stated “When Charlie and I read reports, we have no interest in pictures of personnel, plants or products. References to EBITDA make us shudder — does management think the tooth fairy pays for capital expenditures? We’re very suspicious of accounting methodology that is vague or unclear, since too often that means management wishes to hide something.”
Later in the 2000 Annual Report, Buffett went on to say “Furthermore, we do not think so-called EBITDA (earnings before interest, taxes, depreciation and amortization) is a meaningful measure of performance. Managements that dismiss the importance of depreciation — and emphasize “cash flow” or EBITDA — are apt to make faulty decisions, and you should keep that in mind as you make your own investment decisions.”
Similarly in the 2002 Annual Report, Buffett stated “Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?”
EBITDA Gone Bad in the Real World
I worked with a business owner not too long ago that was entirely too focused on EBITDA. He managed his day-to-day operations based primarily on this metric. Seriously, I cannot overstate how much he ignored everything else, even with a very large outstanding credit line that wasn’t the best interest rates before interest rates went up.
You can probably already see where this is going… how the owner over-extended his company on credit, interest rates went up and his variable interest rate shot up too. He thinks he is running a healthy company because his EBITDA looks really good. But now, he can’t pay all his bills and is on the verge of bankruptcy and the bank is considering calling the line of credit (which means he’d have to repay it in full right away).
And don’t forget that those credit lines for smaller businesses also usually come with a personal guarantee for the business owner.
This is the kind of thinking that Buffett meant when he said that owners that overuse EBITDA are apt to make faulty decisions.
If EBITDA is Bad, What Do I Use Instead?
I can’t just come in here and shit all over EBITDA without telling you what to use instead. For most small businesses, you should be focusing on your Net Income.
Yep, that’s right – no need to do any calculations. Just take that Net Income right off your income statement and go! That number already includes all the earnings information you need.
Well, maybe… as an attorney and an accountant, you know that I have to come back and say that it might not include absolutely everything. See, it will for corporations. But LLCs, partnerships, and sole proprietorships – often your taxes are not on the business income statement. Instead, your income taxes will be outside the entity and on the personal level. So you may have to subtract that amount from your earnings.
Want to know what legal entity is right for you? Then check out this course on Choosing Your Legal Entity.
Need to estimate what those taxes are? Rule of thumb is usually 30-40% of your net income should be set aside for potential taxes for the year.