CFOs and controllers rely on a broad range of key performance indicators (KPIs) to shape the company mission, guide financial decision-making processes, and help their organizations thrive. Some of the KPIs that CFOs and controllers leverage include revenue growth rate, days sales outstanding (DSO), current accounts payable, and current accounts receivable.
Alone, each of these metrics is an important piece of the financial puzzle. Cumulatively, they provide CFOs and controllers with a holistic view of the company’s financial health and performance.
With that being said, to gain a complete picture of the company’s finances, CFOs also have to track earnings before interest, taxes, depreciation, and amortization — or “EBITDA.” Let’s dive deeper into this metric, discuss its importance, and examine how it compares to some other common KPIs.
What Is EBITDA?
EBITDA attempts to represent the cash profit a company will generate by removing non-cash depreciation, taxes, debt costs, and amortization expenses. It is often used to measure profitability and is an alternative to net income.
EBITDA is not recognized under generally accepted accounting principles (GAAP), but some companies still include it in quarterly earnings reports. However, some in the financial arena are critical of EBITDA, as it does not include capital costs. By omitting capital costs, it can yield inflated profitability calculations.
EBITDA vs. Gross Profit Margin
EBITDA and gross profit margin both indicate what a company has earned. However, each metric uses a different formula to calculate profits and earnings. Both formulas provide insights into an organization’s profitability by removing certain costs or expenses. As a result, each can provide a glimpse into profitability.
Gross profit margin indicates a company’s revenue after removing the costs associated with providing its services or manufacturing its products. EBITDA also removes amortization, depreciation, taxes, and interest.
Generally speaking, gross profit margin is used as an internal analytics metric. CFOs and controllers can use gross profit margin to consider how effective the business is at using its materials and labor resources to generate a profit.
Conversely, EBITDA is a comparative metric that can be used to analyze how two businesses or industries stack up in terms of profitability.
EBITDA vs. Operating Cash Flow
When CFOs and controllers need to measure how much cash their organization is generating, operating cash flow is the more useful KPI. Like EBITDA, operating cash flow includes amortization and depreciation. However, it accounts for AP and AR, inventory that uses or provides cash, and changes to working capital.
EBITDA certainly has its uses. But relying solely on this metric does not provide controllers and CFOs with enough insights into the efficacy of accounts payable and accounts receivable processes.
How to Calculate EBITDA
If your organization does not already calculate EBITDA, you can easily do so using information already contained in your company’s income statement and cash flow statement.
To begin your calculations, find your earnings before interest and taxes (EBIT), also known as operating profit. Next, add amortization and depreciation back into your calculation.
Your formula can be structured in one of two ways:
Net income + taxes + interest expenses + amortization & depreciation = EBITDA
Operating income + depreciation & amortization = EBITDA
Both calculations will allow you to quickly determine your organization’s EBITDA. After running your calculation, you will notice the significant disparity between this figure and your gross profits, operating cash flow, and EBIT.
Why Is Tracking EBITDA Important?
EBITDA can provide insights into how amortization and depreciation impact the cumulative profitability of your organization. You can use this data to better understand your company’s revenue model and identify potential savings opportunities.
Additionally, calculating EBITDA and presenting the metric to stakeholders can provide them with additional information about company performance. You can use this metric to build trust and demonstrate your company’s revenue-generating capabilities.
Potential Drawbacks of EBITDA
Since EBITDA is not a GAAP metric, it is possible to deviate from the standard calculation methods outlined above. Another concern is that EBITDA calculations can be misleading if it is the only metric an organization publicizes when discussing profits.
Perhaps the biggest shortcoming of EBITDA is that it does not include the costs of assets, which are critical variables used in revenue calculations.
To maximize transparency and provide investors with the full picture, CFOs and controllers need to also feature other metrics within their reports, such as operating cash flow and gross profit.
EBITDA: An Important Part of the Financial Puzzle
EBITDA is a critical part of the financial puzzle. However, this metric alone is not enough to inform decision-making. To provide adequate guidance to their organizations, CFOs and controllers must examine EBITDA in the context of other metrics, such as working capital, operating cash flow, and others.
By considering the big picture, CFOs and controllers can help their businesses adapt to shifting economic conditions and achieve sustained financial success.
Check out the other KPIs in our series below: