EBITDA and net income are two of the most commonly used financial metrics for assessing a business’s financial performance. But what are the differences between the two terms? Here, you’ll learn when to use EBITDA versus net income, plus the pros and cons associated with them.
What is EBITDA?
EBITDA stands for earnings before interest, depreciation, taxes, and amortization. It serves as a key profitability measure, allowing businesses to assess operational performance without the influence of financial and accounting decisions. Understanding EBITDA can guide strategic financial planning. Let’s look at each component:
Earnings
In the context of EBITDA, earnings generally equate to all business revenue minus cost of goods sold (COGS) and overhead expenses. COGS includes costs that go directly into selling your business’s products—like inventory, raw materials, and wages. Overhead expenses would include things like rent on a storefront, web hosting services, and insurance.
Interest
Interest is the price you pay to borrow money from a lender, usually spread out over a course of several years. Borrowers pay interest on top of repayments on the loan’s principal, or the initial loan amount.
Depreciation
Depreciation expense refers to an asset’s loss in value over time. Examples include company vehicles, equipment, and computers, all of which wear out with use.
Taxes
Businesses in the US are subject to both state and federal corporate income tax, and sometimes county and local taxes. Tax expenses will depend on a variety of factors, including where your business is located, where you sell products, the types of products you sell, the type of business you run (corporation, LLC, etc.), and any credits and subsidies your business may be entitled to. Companies that are not profitable may be exempt from income tax, though other types of tax may still apply.
Amortization
Amortization expense is the gradual reduction in value of intangible assets—like patents, copyrights, and goodwill—over their useful life.
EBITDA formula
A company’s EBITDA can be represented by one of two formulas:
EBITDA = net income + I + T + D + A
EBITDA = operating income + D + A
The first formula uses net income, explored in more detail in the next section, to calculate EBITDA. The second uses operating income, also known as operating profit. Operating income refers to the company’s profit after deducting operating costs such as utilities on a rented storefront or business insurance premiums.
What is net income?
Net income, or net profit, is the amount of money a business has after taxes and all other expenses have been paid. It’s calculated by taking total revenue or sales and subtracting COGS, operating expenses, interest expenses, and taxes. It is the final line item on a business’s income statement and for this reason it’s often called the bottom line. A high net income indicates that the business is doing well, has adequate pricing in place, and is properly covering its expenses.
The formula for net income is as follows:
Net income = total revenue – total expenses
For example, if a business generates revenue of $100,000, and incurs expenses of $80,000, then its net income would be $20,000.
Net income as a percentage of total revenue is called net profit margin—which is used to determine whether net income is sufficient within the full picture of a company’s finances. As a rule of thumb, if net profit margin is less than 10%, profits are considered insufficient. If net profit margin is between 10% and 20%, profits are considered average to good. Anything greater than a 20% net profit margin is considered excellent.
EBITDA vs. net income
There are some key similarities and differences between EBITDA and net income, including:
Similarities
- Precision: EBITDA and net income both measure a company’s earnings, and they both subtract COGS.
- Valuation: Both EBITDA and net income can help potential investors assess a company’s current value and its potential.
- Regulation: EBITDA and net income are both common metrics in business, and they’re both calculated using relatively standard formulas.
Differences
- Precision: EBITDA highlights a company’s earnings without taking into account the cost of interest, depreciation, taxes, and amortization. Net income shows total earnings after these costs are subtracted. A company’s net income is thus a more precise measure of profitability because it takes into account all the costs the business must absorb. A favorable EBITDA can be misleading if a company has a lot of non-operating expenses, such as interest expense.
- Valuation: EBITDA can be a better showcase of a business’s day-to-day operations and cash flow. Net income paints a more realistic and comprehensive picture of a business’s current profitability.
- Regulation: EBITDA is not an official or regulated financial measure, while reported net income must adhere to generally accepted accounting principles (GAAP). This means that companies have more flexibility in how they define the variables that go into an EBITDA calculation. This lack of standardization can make it difficult to compare EBITDA between businesses.
Benefits of EBITDA
Some practical benefits of using EBITDA to measure a company’s performance include:
Better measure of cash flow
Since EBITDA shows income before non-cash expenses (expenses like depreciation and amortization that are recorded on an income statement without any cash changing hands), it’s a better indicator than net income of a business’s ability to bring in cash. For financial analysts, investors, and lenders, this may make EBITDA a better measurement of a company’s core business operations.
Easy to calculate and interpret
EBITDA is very simple to calculate. It can be determined by looking at a company's income statement, taking the net income, and simply adding back cash subtracted for interest, depreciation, taxes, and amortization. EBITDA is also fairly simple to interpret—a higher EBITDA is better. There’s no need to analyze it as a percentage of overall earnings, like net income, to get a sense of a company’s financial performance.
Removes unique variables
EBITDA takes variables that are distinct from business-to-business out of the equation, like tax rates, financing costs like interest rates, and the interpretable value of assets. In this way, it is a preferred metric to compare the performance of companies in the same industry.
Drawbacks of EBITDA
Some limitations of calculating EBITDA include:
Ignores problems
EBITDA focuses on baseline profitability and ignores capital expenditures, which can be substantial. Therefore, some see its use as minimizing certain financial burdens, which may mean it doesn’t fully reflect the business’s risks.
Not recognized by GAAP
EBITDA is not recognized by generally accepted accounting principles (GAAP)—a set of commonly followed accounting rules and standards for a company’s financial statements and reporting. This means businesses are free to interpret the formula and potentially manipulate it.
Misleads on liquidity
The profit indicated by an EBITDA calculation doesn’t paint the full picture of a business’s financial liquidity. Significant portions of the business’s profit might be earmarked for tax payments, or interest payments on business loans, mortgages, and bonds. In other words, the business may have less financial flexibility than it seems based on EBITDA.
Benefits of net income
There are a few benefits of using net income to assess a business’s financial health:
Paints an accurate real-time financial picture
By taking into account all liabilities, net income indicates a company’s total profit, not just its operating profit. It also gives a better sense of the company’s liquidity, or cash on hand, compared with EBITDA, which doesn’t account for cash that must cover interest, tax, and other costs.
Accepted by GAAP
Net income is a measure recognized under GAAP, which means those who prepare financial reports have less flexibility when it comes to calculation and interpretation. All publicly traded companies must report financial results that meet GAAP.
Useful for measuring shareholder value
Net income is a widely recognized measure for assessing individual shareholder value. It is used in calculating earnings per share, a key valuation measure of publicly traded stocks. And because dividends are paid out of net income, investors can be assured of the reliability of this income stream when a company’s net income is high.
Drawbacks of net income
Some disadvantages of using net income include:
Harder to interpret
To interpret whether net income is good or bad, it must be understood within the context of overall revenue or cash earnings. An analyst therefore needs to calculate net profit margin, which is net income calculated as a percentage of sales or revenue. The higher the net profit margin percentage, the better a business’ financial health. Calculating EBITDA, meanwhile, requires less math, using simple addition and subtraction to reach a raw number result.
Impacted by one-offs
Net income can be temporarily inflated or depressed by one-time events, like the gain on a sale of a large asset or a loss when a disaster temporarily shuts down operations. These events distort the true profitability of a company by temporarily boosting or reducing net income.
Less useful for comparing companies of differing capital structures
Because net income includes variable deductions like interest and taxes, it’s not especially helpful for comparing a company’s financial performance across an industry. Without these comparisons, it can be difficult to determine a business’s operational efficacy or an appropriate profit level.
EBITDA vs. net income FAQ
Why is EBITDA used instead of net income?
EBITDA often is used to showcase a company’s potential profitability because it doesn’t account for fluctuating costs that could come and go over the company’s lifetime. In this sense, it’s also preferred to draw comparisons between companies in the same industry, by removing variable costs specific to an individual business.
How do you convert EBITDA to net income?
You convert EBITDA into net income by subtracting depreciation, amortization expenses, financing costs, and taxes.
Is EBITDA more conservative than net income?
When assessing a company’s overall financial health, EBITDA is a less conservative metric than net income. That’s because net income takes into account a variety of costs that ultimately eat into the EBITDA profitability calculation.
