EBITDA Explained In Plain English

EBITDA Explained In Plain EnglishEBITDA Explained In Plain English

Lenders like using a ratio known as EBITDA, it stands for Earnings Before Interest, Taxes, Depreciation, and Amortisation.

It’s a measure of a company’s overall financial performance and is used as an alternative to judging lending affordability using net profit. There are good reasons why lenders use this figure over net profit, first let me explain how EBITDA works.

The Restaurant Analogy

Imagine you own a small restaurant. At the end of the month, you count how much money you made from all the food and drinks you sold.

  1. Earnings: This is the total amount of money you made from sales.
  2. Before Interest: Imagine you took a loan to start your restaurant. The interest is what you pay back to the bank. But for now, we’re not thinking about that.
  3. Before Taxes: You also need to pay taxes on your profit, but we’re ignoring that for now too.
  4. Before Depreciation: Your kitchen equipment, tables, and chairs lose value over time (wear and tear). We’re not considering that loss of value right now.
  5. Before Amortisation: If you bought the building or some expensive equipment on an installment plan, you spread the payment over many years. We’re not considering those payments right now either.

The figure you get after this is, in really simple terms, your EBITDA.

Why Do Lenders Like EBITDA?

There is an old saying, turnover is vanity, profit is sanity, and cash flow feeds the family. It’s true. For a lender they take feeding the family as repaying their lending.

Profit will not repay any lending, cash will. EBITDA helps a lender see the difference between profit and cash.

Take a business that has purchased new assets, they may have written the whole value of those assets off in year one and reduced their net profit as a result, that’s fair as that is what the scheme is there for, but the accounts will show minimal net profit. Can they afford to borrow? Yes, because EBITDA adds back in the depreciation of those assets.

The challenge is that many SMEs don’t understand EBITDA and therefore don’t understand what a lender is telling them, by understanding EBITDA and cash flow it immediately puts the business in a stronger position to borrow.

If you want more details or want to know your options when it comes to lending then get in touch.

By Dave Farmer