Understanding EBITDA: Key Financial Metrics Explained

In this blog, we will delve into the financial terms EBIT (Earnings Before Interest and Taxes) and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and explore their significance in the realm of finance.

Context and Financial Statements:

To provide a foundation, let’s begin by understanding where EBIT and EBITDA fit within the three primary financial statements: the balance sheet, the income statement, and the cash flow statement. The balance sheet offers an overview of an organization’s assets and liabilities at a specific point in time. The income statement showcases the profit or income generated during a given period, while the cash flow statement details the cash inflows and outflows during that period. EBIT and EBITDA are metrics derived from the income statement.

EBIT and EBITDA Definitions:

EBIT represents earnings before deducting interest and taxes, allowing us to focus solely on the operational performance of a business. By excluding interest expenses, which vary based on financing structure, and taxes, which depend on geographical factors, we obtain a clearer picture of operational profitability.

EBITDA takes the analysis a step further by also excluding depreciation and amortization expenses from the earnings calculation. Depreciation and amortization are non-cash expenses that relate to past investment decisions and do not directly reflect current operational performance.

Income Statement Overview:

To better understand the placement of EBITDA and EBIT within the income statement or earnings, let’s examine its structure. Starting with revenue, we subtract the cost of sales to arrive at the gross profit. Deducting selling, general, and administrative expenses (S,G&A) as well as research and development (R&D) expenses from the gross profit, we calculate EBITDA. Next, we subtract depreciation and amortization to obtain EBIT. Finally, EBIT is adjusted further by deducting interest and taxes to arrive at net income.

Terminology Variations and Usage:

It’s important to note that different companies may use varying terminology, so the specific terms employed may differ from those presented here. Furthermore, not all companies report both EBITDA and EBIT; the inclusion of these metrics depends on the company’s reporting practices.

EBITDA’s Significance and Industries:

EBITDA is commonly used as a metric in capital-intensive industries such as manufacturing, trucking, oil and gas, and telecom. In contrast, service-oriented industries like consultancy often do not distinguish between EBITDA and EBIT, as their operations differ in nature.

Understanding Depreciation:

To illustrate the concept of depreciation, let’s consider a scenario where a company purchases a truck for product delivery purposes, costing $100,000. This transaction reduces cash by $100,000 while increasing fixed assets (or “plant and equipment”) by the same amount. However, it would be incorrect to consider the full $100,000 as an immediate cost for the current year since the truck will be utilized over several years. This is where depreciation comes into play.

Suppose the truck has a useful economic life of five years and no residual value. Utilizing straight-line depreciation, we would book $20,000 per year as depreciation expense. This gradual reduction in the asset’s value on the balance sheet is mirrored by recognizing the $20,000 expense on the income statement.

How banks make lending decisions for business loans

When making lending decisions for a business loan, banks look for specific criteria to assess the borrower’s ability to repay the loan. While the process is similar to obtaining a home mortgage, there are some key differences, such as the focus on cash flow rather than personal income. Here are the factors that banks consider:

Cash Flow: Cash flow is of utmost importance to lenders. They want to ensure that the business generates enough cash flow to cover the loan payments. EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a crucial measure of cash flow that banks examine closely.

EBITDA and Debt Service Coverage Ratio (DSCR): Banks analyze the EBITDA of the business and compare it to the loan payment amount. The DSCR is the minimum ratio required between EBITDA and debt service (loan payments). For loans involving real estate, the typical minimum DSCR is 1.25, while for loans without real estate, it is 1.5. This ensures that the business has sufficient cash flow to meet its financial obligations.

Collateral: Similar to home mortgages, banks may also consider the collateral available for the loan. Collateral provides security for the lender in case the borrower defaults on the loan. It could be business assets, real estate, or other valuable assets that can be used to recover the loan amount.

Credit Score: The borrower’s credit score is evaluated to assess their creditworthiness. A higher credit score indicates a lower risk of default and may improve the chances of loan approval.

In conclusion, banks focus on the cash flow of the business, as measured by EBITDA, to determine the borrower’s ability to repay the loan. They also consider the DSCR, collateral, and credit score as part of their evaluation process. It is essential for business owners to plan ahead, ensure strong cash flow, and meet the minimum requirements set by banks to increase their chances of obtaining a business loan.