What is EBITDA? How to calculate it and how lenders use it

EBITDA stands for earnings before interest, taxes, depreciation and amortisation, and the British Business Bank describes it as a form of operating profit. It strips out the costs of how a business is financed and how its assets are accounted for, so you can see what the day-to-day trade earns.

The measure became popular in the 1980s, during the era of leveraged buyouts, when investors used it to judge whether a restructured business could afford the interest on its debt. Today it is a standard figure in finance conversations, including conversations with a lender.

It sits alongside the figures in your profit and loss account. EBITDA is worked out from the lines in those figures rather than being a cost you pay.

Each letter after the E is a cost that EBITDA adds back to earnings. The British Business Bank sets out what each one is.

Net profit is your total revenue from sales minus the costs you deduct as legitimate business costs. Our guide to net profit covers that first step.

You can calculate EBITDA in two ways: add depreciation and amortisation to operating profit (EBIT), or add interest, tax, depreciation and amortisation back on top of net profit. Both routes give the same answer.

The two columns meet because operating profit already sits above interest and tax: £60,000 plus £10,000 plus £12,000 is £82,000. Ask your accountant which line in your own accounts is the right starting point, as accounts differ in how they present these items.

EBITDA is not the same as net profit and it is not cash. Net profit is what is left after every cost, including interest, tax, depreciation and amortisation. EBITDA adds four of those costs back, so it is almost always the larger figure.

It is also not a cash figure. EBITDA does not show the money you spend on new equipment, the cash tied up in stock and unpaid invoices, or the interest and tax you actually have to pay. A business can show a healthy EBITDA and still be short of cash in a given week.

• EBITDA shows what the trade earns before financing, tax and accounting charges.
• Net profit shows what is left after all costs.
• Cash flow shows whether money arrives in time to pay each bill. See our guides to free cash flow and working capital.

Lenders look at EBITDA because it gives a quick view of whether a business generates enough operating profit to repay what it borrows. The British Business Bank says that if you approach a bank for a business loan or another form of finance, it will likely use EBITDA to determine whether your business is able to repay its debts.

Because EBITDA ignores how a company is financed, it also lets a lender compare businesses that fund themselves in different ways, through debt, equity or cash. It is one input among several. A lender will also look at the balance sheet, your trading history and the purpose of the borrowing, and each lender sets its own criteria.

To see the other side of the picture, read about the balance sheet and the interest cover ratio, which asks whether profit comfortably covers interest payments.

The debt to EBITDA ratio measures a company’s ability to pay off its debt: total debt divided by EBITDA. A high ratio may indicate that the debt is too heavy a financial burden.

Read as a rough guide, 2.5 means it would take about two and a half years of EBITDA to cover the debt. Again, the numbers are made up to show the sum and are not a target. Each lender decides what ratio it will accept, and it varies with the lender and the product.

Adjusted EBITDA is EBITDA with extra items removed or added back, usually one-off costs that are not part of normal trading. There is no single official list of adjustments, so a lender may accept some and challenge others.

If you are preparing figures for a lender, keep the adjustments few, explain each one and have your accountant check it. An adjustment that cannot be evidenced from your records is likely to be questioned, and a plain EBITDA you can reconcile to your accounts is more credible than a flattering one you cannot.

EBITDA is a poor guide when a business spends heavily on equipment, carries a lot of stock or pays substantial interest and tax, because those costs are exactly what it leaves out.

• A business that must keep replacing vehicles or machinery pays for that replacement in cash, even though depreciation is added back.
• A business with slow-paying customers can show good EBITDA while the money sits in unpaid invoices.
• A negative EBITDA means the core trade is losing money before any financing or accounting charges, which is a serious warning sign for a lender.
• A lender may weigh other evidence alongside EBITDA, such as your balance sheet and trading history.

For that reason lenders rarely rely on one number. Different products are assessed in different ways, and our overview of the types of lender shows how providers specialise.

Capzy is a credit broker, not a lender, and is paid by the lender. We introduce businesses to lenders and set out what comes back so you can compare it, whatever measures those lenders use to assess you.

You can check your funding options with a soft search that does not affect your credit score. A full application to a lender may involve a hard search, and any offer is subject to status and lender criteria. We do not give accounting or tax advice, so ask your accountant to check your EBITDA and the figures behind any decision to borrow.