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EBITDA vs. Net Income: What You Should Know
By Lauren Winigrad
Whether you are a current business owner or are considering purchasing one in the future, it is vital to have a clear understanding of the differences between EBITDA vs. net income. While EBITDA and net income may seem quite similar at first glance, there are some key distinctions to pay attention to.
This article explains both net income and EBITDA, as well as compares the different applications for each metric.
Net income is one of the more closely watched financial metrics in any company. It is a simple, easy-to-find metric that reveals how a company is performing.
Calculating Net Income
Simply put, net income is a company’s total revenue minus total expenses. More specifically:
Net income = Revenue – Cost of Goods Sold – Expenses (including taxes).
If you are evaluating a prospective company to purchase or are considering an investment, net income appears clearly on the income statement.
Understanding Net Income
Net income is also sometimes called Net Profit or Net Earnings. It is a measure of the profitability of a company.
In addition, since it is often denoted on the bottom line of financial statements, it is also referred to as “the bottom line”.
Net income reflects a company’s total earnings or profitability. In addition, it is often used to calculate a company’s earnings per share (EPS). Given its importance, it is easy to see why net income is one of the primary metrics that people pay attention to when evaluating a company’s financial statements.
Unfortunately, some companies unduly influence their net income for strategic purposes. They do this by inflating revenue, hiding expenses, or both. As such, it is extremely important to ensure that the company’s financial statements use accurate and timely information.
While often discussed less than net income, EBITDA is still a crucial metric to pay attention to, both for a business owner or those looking to purchase a business. Knowing what it is and how to calculate it can yield important insights into the performance of a business.
What is EBITDA?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Essentially, it is the earnings that a business owner realizes before incurring non-cash expenses. Another way to put this is that EBITDA does not account for expenses not directly related to operating the business.
EBITDA is a common method for analyzing the financial performance of a company’s core business operations.
Before jumping in further, let’s define several terms used in the calculation of EBITDA. These are:
A depreciation expense refers to the reduction in the value of a company asset over time, often due to normal wear and tear. An amortization expense refers to gradually paying off a debt or asset over time, usually with regular payments.
An interest expense refers to any interest that a company pays due to a loan or other source of credit. Therefore, you should add back each interest payment that the company makes in a given period to net income.
The tax expense, of course, would refer to an income tax or other taxes that the company needs to pay.
By stripping out these costs, EBITDA provides an income figure that focuses solely on the core costs of doing business.
However, taxes, interest, amortization, and depreciation can change based on the size of the company, the tax bracket that the company falls into, and the current state of company assets. This is because they are outside of the core costs of doing business.
EBITDA is often used when comparing the performance of two different companies of various sizes. Since it casts aside costs such as taxes, interest, amortization, and depreciation, it can yield a clearer picture of the money-generating performance of the two businesses compared to net income.
Additionally, EBITDA is crucial when calculating other important metrics such as the EBITDA margin or the Net Debt to EBITDA ratio.
The EBITDA margin is a measure of the company’s operating profit, or operating income, as a percentage of its revenue. This metric allows further comparison between two businesses within the same industry. The Net Debt to EBITDA ratio is essentially a measure of a company’s leverage.
EBITDA and operating cash flow often cause confusion. While they share some similarities, they are not the same. Like EBITDA, Operating cash flow starts with net income and adds back expenses such as depreciation, changes to inventory, and changes to accounts receivable. As you can see, some of these expenses vary from the metrics used in calculating EBITDA.
Calculating EBITDA is fairly straightforward in principle. Most company balance sheets do not list EBITDA directly. However, it is easy to calculate by looking at the available information and applying a simple EBITDA formula. This formula is:
EBITDA = Net income + Interest + Taxes + Depreciation + Amortization.
As you can see, net income is the starting point for calculating EBITDA. As such, EBITDA will almost always be higher than net income.
When looking at an accounting record of a given company, simply start with the net income and then add the Interest, Taxes, Depreciation, and Amortization to the figure to calculate the EBITDA.
As with net income, some companies try to inaccurately alter the figures used to calculate EBITDA on their income statement to present a more favorable picture. For this reason, it is essential to verify that you are using accurate information when evaluating a business for purchase.
Likewise, if you are a business owner, this underscores the importance of keeping rigorous accounting records. Whether you do so independently or hire a bookkeeper is up to you.
EBITDA and Business Valuation
EBITDA is also a highly relevant valuation metric. Whether you are looking for a business to purchase or are considering selling your own, it is crucial to know how to value a business.
We won’t go into detail about business valuation here. At a basic level, however, the value of a business is often calculated by taking an earnings figure and multiplying it by a number. We call this number ‘the multiple.’
While valuation multiples can range based on a variety of factors, the earnings figure is often much more concrete when calculated correctly. In certain situations, we use EBITDA to calculate the figure that is being multiplied.
When a business is being valued, it makes sense to ascertain the true earning potential that the company has. That is, how much income the business generates before the expenses that are not from core-business generating activities.
As we have seen, EBITDA is a better figure for determining this when compared to net income. However, it’s more common to use Seller’s Discretionary Earnings than EBITDA when valuing a business.
EBITDA and SDE
Like EBITDA, the Seller’s Discretionary Earnings are the earnings that a company generates before accounting for certain expenses. For SDE, these expenses include:
- Non-Cash expenses
- One time investments
- Owners benefit
- Any unrelated income or costs
As you can see, EBITDA and SDE are quite similar. However, the main difference between the two is that the SDE includes the owner’s benefits such as the salary and personal expenses.
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Comparing Net Income and EBITDA
While we have already discussed both net income and EBITDA, we’ll briefly review how the two differ. To do so, let’s consider a scenario that will highlight the differences in their calculation and significance.
EBITDA vs. Net Income
Let’s say that you are considering purchasing one of two companies within the same industry. When you look at the net income for both companies, you see that they each earn $100,000 per year. Based on this metric, you may assume that these two companies are quite similar.
However, when you look at the EBITDA, the picture may change. Let’s say that one of the companies, Company A, is currently paying $30,000 more in taxes and has an additional $10,000 interest expense per year when compared with Company B. When you calculate the companies income in EBITDA terms, you can see that Company A is currently generating $140,000 per year, while Company B is still only generating $100,000.
The Importance of Net Income
It is still important to look at overall earnings in the form of net income. However, it is also essential to look at the earnings of the core business operations and costs. For example, perhaps it is possible to legally lower the tax expense of Company A by $30,000 per year. Overnight, the net income of Company A goes up by $30,000.
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In addition, perhaps the loan that is incurring interest will be fully paid off within one year. At that juncture, Company A eliminates their $10,000 interest expense, driving up the net income by an additional $10,000. Suppose a company is engaging in debt financing to drive growth or purchase fixed assets. In that case, this can create larger interest payments and thus larger differences in that company’s EBITDA and net income figures.
At the end of the day, it can be easy to see why Company A could be preferable to Company B in this scenario. With a few simple changes, Company A suddenly has a net income, or Net Profit, of $140,000 while Company B still has a net income of $100,000. However, you wouldn’t be able to tell this if you were only comparing net income. By looking closely at EBITDA, we can identify these differences.
Earning Potential vs. Earnings Per Share
Lastly, it is important to note that you use net income and EBITDA to calculate two different figures. As we have seen,
For public companies, you use net income to calculate the actual Earnings Per Share, or EPS. You calculate the Earnings Per Share by dividing the company’s profit by the outstanding shares of its common stock. For investors, the EPS is an important figure, and thus, the net income.
Net income and EBITDA both reveal important insights about a companies performance. While net income shows how much a company earned in a given period, EBITDA is useful for determining the income-generating potential of a given company.
Due to these differences, EBITDA and net income are useful in different situations. For those wishing to purchase a company, looking at the EBITDA (or, more likely, the SDE), will help you arrive at an accurate valuation for that company. For investors concerned with how much their stock holdings will earn them in a given year, the net income is more relevant.
Given the similarities, it is important to understand the differences between EBITDA and net income. By doing so, you can make more informed decisions when evaluating the performance of a business, whether it is your own or one that is for sale.