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EBITDA: Understanding what it means for your startup

EBITDA is one of the most-used and scrutinized metrics in the startup ecosystem, but what does it mean—and why should you care? EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization, and it’s used to quickly measure your company’s operational profitability.

That’s a fancy way of saying how much revenue your business makes after taking away costs to make or sell them—but before you pay taxes and interest on loans.

Understanding EBITDA can pave the way for informed decision-making and strategic planning. It’ll help you better comprehend your financial health and convey it to those who hold the keys to your startup’s next chapter.

Below, we’ll walk you through everything you need to know about EBITDA, including its limitations and practical applications in the startup world.

What is EBITDA?

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s a financial metric that provides a lens to examine a company’s financial performance without getting tangled up in the web of tax environments, financing decisions, and accounting practices.

Let’s break down each component of EBITDA:

  • Earnings: The total revenue (all the money earned from selling products or services) minus the cost of goods sold (the money spent to make those products or services). Also known as net income.
  • Interest: The cost of debt financing (like loans or credit).
  • Taxes: The amounts paid to the government can vary and thus are excluded.
  • Depreciation: The decrease in value of tangible assets (like machinery or buildings) over time.
  • Amortization: Similar to depreciation, but for intangible assets (like patents or trademarks).

EBITDA isolates earnings to empower startups and investors to gauge the value and viability of the business, separate from external financial factors. It helps determine operating income and operating profit to know how a business is performing operationally.

Here’s the common formula for calculating EBITDA:

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

The significance of EBITDA for startups

EBITDA helps you to make your startup shine in the eyes of stakeholders and investors. Despite financial hurdles and other obstacles, you might have a completely viable business—and that’s what EBITDA lets you showcase.

It provides a somewhat purified view of your operational activities, free from the distortions of varied accounting and financial practices.

For your startup, this means spotlighting the financial fruits of your innovative labors, opening the way for informed strategies, data-backed investment decisions, and transparent communication with stakeholders.

Here’s why EBITDA matters for your startup:

  • Evaluating operational profitability: EBITDA allows startups to present a clear picture of their net income derived purely from core business activities, such as selling a product or providing a service, by sidelining factors like taxes and interest expense.
  • Investment and funding implications: Investors and venture capitalists often scrutinize EBITDA to understand a startup’s ability to generate profit from its operational activities, which can determine funding decisions.
  • Comparing financial performance: EBITDA facilitates a standardized comparison of financial performance across the industry, enabling startups to benchmark against peers and competitors without the variance caused by financial, tax, and accounting practices.
  • Decision-making and strategic planning: Armed with insights from EBITDA, startup leaders can make informed decisions, strategize future paths, and align their operational activities to enhance profitability.
  • Communicating financial health: EBITDA serves as a tool to communicate a company’s financial health and potential to stakeholders, investors, and even team members by focusing on net income from core operations.

Pros and cons of using EBITDA

While EBITDA can be a valuable metric for your startup, it doesn’t tell the whole story. Like any metric, EBITDA comes with its own set of advantages and disadvantages that startups need to be mindful of to use it effectively.

Advantages of EBITDA

  • Simplicity and accessibility: EBITDA offers a relatively simple and accessible way for startups to assess their operational profitability without getting entwined in the complexities of taxes, interest, and depreciation and amortization.
  • Investor attraction: Investors often look at EBITDA as a quick gauge of a startup’s operational profitability and potential for growth, making it a valuable metric for attracting investment.
  • Industry comparisons: EBITDA allows for a standardized comparison across the industry, enabling startups to benchmark their operational profitability against peers and competitors.
  • Focus on operations: By excluding non-operating expenses, EBITDA clearly shows a company’s profitability from its core business activities, highlighting your company’s operating performance.

“Measuring your startup’s EBITDA is essential for making intelligent decisions about how to allocate funds and grow your business over time,” says Joanna Coleman, Managing Director of Burkland’s Bookkeeping & Accounting Group. “This metric provides an accurate picture of how much revenue your company generated after accounting for all necessary expenses and helps potential investors understand what kind of return they would get if they invested in your business down the line.”

Limitations of EBITDA

  • Ignores capital expenditures: EBITDA doesn’t account for capital expenditures (CapEx), which are crucial for maintaining and growing a business, potentially painting an overly optimistic picture of financial health.
  • Overlooks debt: By adding back interest expenses, EBITDA can sometimes mask the impact of debt on a company’s profitability, which can be risky for startups with significant borrowings.
  • Absence of tax consideration: EBITDA disregards tax implications, which are a significant factor in a company’s net income and cash flow.
  • Potential for Manipulation: EBITDA can be manipulated by altering the inputs of its calculation, such as categorizing expenses to inflate the figure, which can mislead investors and stakeholders.

“Too many managements – and the number seems to grow every year – are looking for any means to report, and indeed feature, ‘adjusted earnings’ that are higher than their company’s GAAP earnings,” says Berkshire Hathaway Chairman and CEO Warren Buffet. " A management that regularly attempts to wave away very real costs by highlighting ‘adjusted per-share earnings’ makes us nervous. That’s because bad behavior is contagious: CEOs who overtly look for ways to report high numbers tend to foster a culture in which subordinates strive to be ‘helpful’ as well."

While EBITDA can provide valuable insights into your operational profitability, your startup needs to use it consistently and judiciously in conjunction with other financial metrics to get a holistic view of its financial standing.

EBITDA’s practical application for your startup

EBITDA isn’t just a number you’ll want to slap on a document or throw around in investor conversations. You’ll want to approach it practically and strategically.

It’s a metric and a tool.

Here are a handful of practical applications you can use EBITDA in for your startup:

1. EBITDA in financial statements

Feature your EBITDA prominently in your financial statements (such as the income statement or cash flow statement) to give a snapshot of your operational profitability.

This communicates your business’s ability to generate profits from core business activities, which will be critical when talking with potential investors and partners.

2. EBITDA in valuation and selling price

EBITDA multipliers can be used to determine the selling price for your startup. By projecting future EBITDA and applying an industry-standard multiplier, your business can validate a valuation that reflects inherent and future profitability.

3. EBITDA in investor communications

Make your EBITDA metric part of your investor updates. Regularly report on this metric and how it affects your startup’s profitability and potential.

4. Strategic planning with EBITDA

Monitor your EBITDA and use it to align your operational activities with financial goals. Using this metric can help you find areas for financial optimization and create strategies to enhance operational profitability.

You can’t always control taxes and interest payments, but you can control the profits you generate with the EBITDA metric.

5. Benchmarking using EBITDA

Use your EBITDA to compare your startup’s operational profitability with other industry peers and competitors. This can help you identify areas of strength and weakness, helping you understand where your startup stands in the same industry ecosystem.

Better manage your operational costs with DigitalOcean

EBITDA can be a powerful tool and metric for your business, but it needs to be used with Buffet’s guidance and hesitations in mind. Don’t twist your numbers to inflate your EBITDA—be reliable and consistent with your reporting to make it powerful data rather than a vanity metric.

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