Can You Tell Us What Your Business' Operating Cash Flow Is Right Now?
It doesn’t matter whether your company is new or you’ve been at it for a while. While the challenges you face will evolve over time, you’ll always be concerned with determining and tracking the financial well-being of your business. After all, projecting profitability with some degree of accuracy is paramount if you hope to anticipate and exceed customer needs. Without some knowledge about what the future may bring, you won’t be able to plan ahead and put your available resources to their most effective use. Thankfully, you can use your financial statements to gauge how well your company is doing.
The EBITDA formula is one of the most comprehensive — and therefore precise — ways to evaluate your business and identify the next steps to keep your company on the road to success. “EBITDA” is an abbreviation for “earnings before interest, taxes, depreciation and amortization;” every business owner should be aware of this approach and how to calculate EBITDA. Before we delve too deep into specifics, let’s have a proper introduction.
As you might expect, there is a learning curve when it comes to applying a tool as powerful as EBITDA. However, it’s not incapable of being mastered. How you interpret your financial numbers can often impact the conclusions you come to and, by extension, the impactful decisions you make. Calculate carefully whenever you run your company’s numbers, especially with a formula like EBITDA.
In the past, this formula had been criticized as a poor indicator of business health, in part because it has been applied incorrectly. Whereas companies traditionally seek to identify their net income (gross revenue minus expenses), EBITDA emerged decades ago with an alternative — and some say more accurate — take.
The formula posits that companies can more closely nail down long-term profitability by setting aside any expenses that can’t be traced back to core operations — specifically the interest, taxes, depreciation and amortization that comprise two-thirds of the formula’s name. Without these so-called distractions muddying up your calculations, you should be able to get a truer sense of your ability to turn a profit. Of course, EBITDA is still best used in certain circumstances, such as straight comparisons between more traditional types of businesses. Nonetheless, distilling the complicated figures of your company’s ledger down to single number has undeniable appeal and could yield vital lessons if wielded properly.
Now that we’ve brought you up to speed on what EBITDA is, let’s go step-by-step on how to put the formula into action.
One of the most useful elements of your EBITDA is how easy it makes it to define your EBITDA margin. This is a reflection of how your EBITDA compares to your revenue, and it’s derived by dividing your EBITDA by your company’s total revenue. The total you’ll arrive at is instrumental for you and any potential investors, as it will reveal how much of an impact your operating expenses are having on your overall profits. If you have a higher EBITDA margin, your company is considered more financially sound and poses a more reasonable risk. If it’s the opposite, you might have some work to do.
Your EBITDA coverage ratio, on the other hand, pits your EBITDA against your company’s liabilities, such as debt and lease payments. Most frequently, the coverage ratio is used as a predictor of your ability to make future payments in a timely manner. This formula is a combination of your EBITDA and your lease payments divided by the sum of your interest payments, lease payments and principal repayments. When complete, you’ll likely have a ratio between 1 and 2. A lower number indicates that you can pay off your debts (perhaps with some struggle), while higher figures are preferable and bode well for your future profitability.
Naturally, it’s in your best interest to achieve optimum results here, since many view your EBITDA coverage ratio as the definitive factor that qualifies the health of your business. Moreover, you can use these numbers as a litmus test for your progress from one year to the next. By keeping tabs on this yourself, you can be more proactive in ensuring your business is healthy, and even identify problem areas before they arise. Reporting as a whole is always a smart move, but it’s doubly important when it comes to your EBITDA coverage ratio.
In case we haven’t made it clear yet, your business absolutely should be utilizing EBITDA to propel itself into a brighter future. By being fully self-aware and in tune with your most meaningful financial figures, you are positioning yourself that much closer to reaching that next milestone. Even though taking on this legwork does add one more item to your never-ending to-do list, the value you’ll receive once you keep your EBITDA formula handy (and the relevant numbers adequately crunched) far exceeds the inconvenience.
But we’re interested in hearing your thoughts on the matter. Maybe you have a success story about how EBITDA helped boost your business and land you a new investor. Perhaps you’ve identified a slightly tweaked approach that amplifies the benefits of the formula. We’re dying to hear what you have to say on the topic. So feel free to share your thoughts, comments or questions with us on Twitter over @Revenued_com.