What is EBITDA? A Simple Explanation That Finally Makes Sense

Most business owners get confused by EBITDA, but here's exactly what you need to know: it's one of the most widely used measures of a company's financial health and cash-generating ability. This metric cuts through accounting complexities to show you how well your core business operations actually perform.

EBITDA—which stands for Earnings Before Interest, Taxes, Depreciation, and Amortization—emerged in the 1970s when billionaire investor John Malone started using it. Today, it's become essential for business valuation and performance assessment. The metric isn't part of generally accepted accounting principles (GAAP), yet it reveals operational performance more clearly by focusing purely on your operating business results. Keep in mind that positive EBITDA doesn't automatically equal high profitability. The SEC actually requires public companies to show how they calculated their EBITDA from net income.

You'll discover exactly what EBITDA means for your business, the right way to calculate it, and when this metric becomes most valuable for your decisions. We'll also examine EBITDA margin interpretation, including industry benchmarks where margins above 15% often signal strong performance across many sectors.

What is EBITDA? A beginner-friendly explanation

This financial metric strips away several expenses to show your company's operational performance. While net income includes every expense your business faces, EBITDA gives you a focused view of your actual earning potential.

Breaking down the acronym

Each letter in EBITDA represents a specific component:

E - Earnings: Your company's net profit before any of the adjustments below.

B - Before: The signal that we're adding back the following expenses to your earnings.

I - Interest: What you pay to borrow money for business operations. EBITDA adds this back because interest reflects financing choices, not how well your operations perform.

T - Taxes: Federal, state, and local tax obligations. These get added back since they vary by location and don't show your business's operational efficiency.

DA - Depreciation and Amortization: Non-cash expenses showing asset value decline over time. Depreciation covers tangible assets like buildings and equipment, while amortization covers intangible assets like patents and software.

What EBITDA includes and excludes

EBITDA focuses on core business operations by removing:

• Interest expenses: Excluded because they reflect financing choices rather than operational performance. Two identical businesses might have completely different interest expenses based purely on their debt structures.
• Tax expenses: Different tax jurisdictions and strategies can dramatically impact net income. EBITDA eliminates this variable to create fair comparisons.
• Depreciation and amortization: These non-cash expenses are subjective and vary significantly between companies using different accounting methods. They also don't represent actual cash leaving your business during the current period.

What you get is a clearer picture of the cash profits your core business activities actually generate.

Why it's useful for business owners

EBITDA delivers several key advantages:

You can compare your business against competitors meaningfully, regardless of differences in capital structure, tax environments, or accounting practices. This shows you where you stand on operational efficiency relative to others in your space.

EBITDA serves as a reliable valuation metric. It's used extensively in business valuations, especially during mergers and acquisitions. Potential buyers calculate your company's worth using EBITDA multiples, making this metric essential for exit planning.

It provides insights into cash flow generation. While not a perfect cash flow proxy, EBITDA gives you a quick estimate of your business's ability to generate cash from operations.

EBITDA helps assess your company's debt capacity. Lenders use debt-to-EBITDA ratios to determine how much additional financing your business can handle.

EBITDA has limitations, though. It excludes capital expenditures necessary for maintaining your asset base and can mask financial stress when used alone. Still, it remains one of the most widely used financial metrics for evaluating operational performance across industries.

How to calculate EBITDA in real life

EBITDA calculations look intimidating, but they're actually quite straightforward once you know where to find the right numbers on your financial statements. Most business owners can master this in minutes.

The basic EBITDA formula

You have two reliable methods for calculating EBITDA, and both should give you the same result. The first starts with net income:

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

The second begins with operating income (also called EBIT):

EBITDA = Operating Income + Depreciation + Amortization

The second formula often proves more direct since it requires fewer adjustments. You'll find these financial figures in your standard financial statements:

• Net income and operating income appear on the income statement
• Interest and tax expenses are listed on the income statement
• Depreciation and amortization figures typically appear in the cash flow statement or financial statement notes

Using net income vs operating income

Your choice depends on which financial information you have readily available.

Starting with net income works well when you're reviewing complete financial statements. This approach adds back all excluded elements (interest, taxes, depreciation, and amortization) to reach EBITDA.

The operating income approach is more direct. Operating income already excludes interest and taxes but includes depreciation and amortization, so you only add back these non-cash expenses.

Here's the key difference: operating income only includes revenue and expenses from core business operations. Operating expenses typically include cost of goods sold (COGS), selling, general, and administrative expenses (SG&A), payroll, and utilities. Net income additionally factors in non-operating income and expenses, such as gains from asset sales.

A real-world example with numbers

Let's work through a complete EBITDA calculation using this company's financial data:

• Revenue: $100 million
• Cost of Goods Sold (COGS): $25 million
• Selling, General & Administrative (SG&A): $20 million
• Research & Development (R&D): $10 million
• Depreciation & Amortization: $5 million
• Interest Expense: $5 million
• Tax Expense (20% rate): $5 million

Method 1: Starting with net income

Net Income: $20 million

• Interest: $5 million
• Taxes: $5 million
• Depreciation & Amortization: $5 million = EBITDA: $35 million

Method 2: Starting with operating income

First, calculate operating income: Revenue ($100M) - COGS ($25M) - SG&A ($20M) - R&D ($10M) = $45 million

Then add back depreciation and amortization: Operating Income ($45M) + Depreciation & Amortization ($5M) = EBITDA: $50 million

Notice our examples show different results ($35M vs $50M). This typically happens when non-operating items impact net income or when depreciation gets embedded within different expense categories. Properly calculated EBITDA should yield consistent results regardless of which method you use.

Always use the depreciation and amortization figures from the cash flow statement to capture the full amount, since many companies don't list the complete D&A expense on their income statements.

How businesses and investors use EBITDA

Once you understand EBITDA calculation, you'll encounter this metric in three critical business situations. EBITDA's widespread use comes from its ability to standardize operational performance comparisons across different business models.

Valuing a business for sale

EBITDA becomes your primary valuation anchor when selling your business. Buyers calculate your company's worth using EBITDA multiples—numerical factors applied to your earnings to determine fair market value. These multiples shift dramatically by industry, reflecting different growth prospects, risk levels, and return expectations.

Public companies typically see enterprise value to EBITDA ratios (EV/EBITDA) around 8x, while private businesses often trade closer to 4x. This approach captures total business performance by incorporating both debt and equity in the valuation.

During mergers and acquisitions, EBITDA provides crucial advantages:

• Eliminates accounting variations between companies
• Creates fair comparisons across different businesses
• Reveals core profitability regardless of financing structure

Companies with lower EV/EBITDA multiples often attract acquisition interest, as they may represent undervalued opportunities.

Assessing loan eligibility

Banks examine your EBITDA to determine how much debt your business can handle. Rather than looking only at revenue, lenders focus on cash flow generation capacity to service debt obligations.

The debt-to-EBITDA ratio becomes central to this evaluation, showing lenders your ability to manage additional financial commitments. High ratios signal potential overleveraging, which could limit borrowing options. Banks frequently set debt-to-EBITDA targets that you must maintain throughout the loan term.

Lenders also embed EBITDA requirements into loan agreements as debt covenants—contractual conditions requiring specific financial thresholds. Falling below these levels can trigger consequences like higher interest rates or additional collateral requirements.

Benchmarking against competitors

EBITDA enables meaningful industry comparisons despite differences in:

• Capital structures
• Tax environments
• Accounting methods

You can identify industry leaders by comparing EBITDA margins (EBITDA divided by total revenue). Higher margins relative to competitors typically indicate superior cost management and operational efficiency.

Tracking your EBITDA against competitors reveals market trends and investment opportunities. Companies expanding into new markets use EBITDA to evaluate average business values in target sectors.

EBITDA benchmarking pinpoints where your business excels or needs improvement compared to industry standards, providing clear direction for strategic planning.

EBITDA margin and what it reveals

EBITDA alone tells you about earnings, but EBITDA margin shows you something more important—how efficiently your business converts revenue into operating cash profit. This percentage reveals whether your operations are actually working or just burning through money.

How to calculate EBITDA margin

The EBITDA margin calculation couldn't be simpler—divide your EBITDA by total revenue and express it as a percentage:

EBITDA Margin = EBITDA / Total Revenue

Take a company generating $100,000 in revenue with an EBITDA of $15,000—that's a 15% EBITDA margin. This percentage shows you the proportion of revenue that remains as operating earnings before financial structure, taxes, and non-cash expenses eat into it.

This calculation reveals the effectiveness of your cost management and operational performance. Unlike net profit margin that includes everything, EBITDA margin zeros in on pure operational efficiency.

What's considered a good EBITDA margin

Good margins vary dramatically by industry, but 15% to 25% generally signals solid performance across many sectors. Technology and software companies typically enjoy higher margins thanks to lower overhead and scalability, while manufacturing or retail businesses often run leaner.

The numbers tell the story:

• REIT-Industrial: approximately 72.4% average margin
• REIT-Retail: around 68% average margin
• Software companies: averaging about 29%
• Nasdaq publicly traded companies: hovering around 30%

Some industries like Biotechnology actually run negative margins (-105.1%) during development phases.

Using margin to track performance over time

Your EBITDA margin trends reveal whether your business is getting stronger or weaker operationally. Stable or rising margins typically indicate solid performance and financial stability.

Declining margins signal trouble—operating costs are outpacing revenue growth. When you spot this pattern, dig into specific expense categories and fix what's broken.

During growth phases, EBITDA margin tracking becomes essential for sustainable expansion. When you're scaling into new markets or launching products, this metric shows whether costs are spiraling out of control relative to revenue growth.

When EBITDA can be misleading

EBITDA has serious limitations that can lead you to poor business decisions if you rely on it alone. Recognizing these shortcomings helps you use this metric more effectively.

Ignoring capital expenses and debt

EBITDA creates a dangerous blind spot by ignoring critical financial realities. It completely excludes capital expenditures needed to maintain and replace your assets. Warren Buffett put it perfectly: "Does management think the tooth fairy pays for capital expenditures?". This becomes especially problematic in capital-intensive industries like manufacturing, shipping, and telecommunications, where equipment investments are ongoing necessities.

EBITDA also ignores debt obligations entirely. When it excludes interest payments, heavily indebted companies can look financially healthy. Charter Communications filed for bankruptcy despite positive EBITDA. Interest and taxes represent real cash that leaves your business—they can't be wished away.

The problem with adjusted EBITDA

"Adjusted EBITDA" creates even bigger problems by allowing companies to manipulate their financial story. Without GAAP standards, businesses make subjective adjustments that create overly rosy pictures.

Companies routinely exclude legitimate business costs by calling them "non-recurring" or "one-time"—even when these expenses happen regularly. Klarna reported $181 million in adjusted operating profit while posting a GAAP operating loss of -$121 million by excluding nearly half a billion dollars in consumer credit losses.

How to use EBITDA responsibly

Smart financial analysis requires using EBITDA alongside other metrics. Examine your actual cash flow statements to understand your real liquidity position. Analyze capital expenditure requirements to assess long-term sustainability.

Evaluate debt levels separately since EBITDA masks this crucial aspect of financial health. Consider industry-specific factors—EBITDA's usefulness varies dramatically across different sectors.

EBITDA works best as one tool in your broader financial analysis toolkit, not as a standalone measure. Understanding its limitations lets you extract valuable insights without falling into common traps.

Conclusion

EBITDA cuts through accounting noise to show you what your business operations actually generate. You now understand how to calculate it properly, when it provides valuable insights, and where it falls short.

This metric works well for comparing your performance against competitors or evaluating potential acquisitions. But Warren Buffett's criticism holds true—EBITDA ignores real expenses like capital expenditures that keep your business running.

Smart financial analysis means using EBITDA alongside cash flow statements, debt analysis, and industry-specific factors. Your EBITDA margin becomes particularly valuable when tracked over time, revealing operational efficiency trends that pure revenue numbers might miss.

The businesses that get into trouble are those that rely on EBITDA alone. Companies have filed for bankruptcy while reporting positive EBITDA because the metric doesn't account for debt service or equipment replacement costs.

Here's exactly what you need to know: treat EBITDA as one important piece of your financial puzzle, not the complete picture. When you combine it with other metrics, you get clearer insights for business valuation, financing decisions, and competitive positioning.

AdaptCFO helps business owners develop this broader financial perspective. Understanding both EBITDA's strengths and limitations gives you better tools for making decisions that actually move your business forward.

If you're looking to get some advice on your finances, book a call with our team here, or get your free Financial Fitness Score here to see where your business stands.