EBITDA in SaaS

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a financial metric used to understand the financial position of a company.

EBITDA puts companies on an equal playing field when used for valuation purposes, removing differences in taxation which can vary from region to region, accounting policies, and interest from debt when estimating the operating cash flow of a business.

For investors, this measure of revenue is one of many financial metrics that can be used to understand and compare a company’s earnings. However, EBITDA comes with significant drawbacks in terms of its accuracy and reliability that need to be considered.

Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) is a way of tracking a company’s earnings or cash flow.

The core components of EBITDA include:

• Net income or earnings: how much money your company generates in a specific time period (such as a quarter or year).
• Interest: an expense typically linked with debt and loans, such as paying interest on top of the principal amount of a business loan.
• Taxes: depending on where a company is operating, you’ll need to pay taxes for things like wages and earnings.
• Depreciation and amortization: over time, some assets will decrease in value. Depreciation refers to the decline in the value of tangible assets (like equipment), while amortization refers to the decline in the value of non-tangible assets (like copyrights or patents).

This metric takes into account the total revenue of a business and adds back the interest, taxes, and depreciation. While EBITDA doesn’t replace other metrics (like operating income), it is another metric used to track a company’s ability to generate cash flow.

If you’re looking to figure out the cash flow of your company, EBITDA might be one of the metrics you choose to calculate.

All the data required to calculate EBITDA should already be included in the business’s income statement and balance sheet.

When it comes to tracking a company’s financial performance, EBITDA can be used to look at how much income you’re making before accounting for things like paying taxes and accounting for depreciating assets.

EBITDA = Earnings + Interest + Taxes + Depreciation & Amortization

By removing many company-specific variables, EBITDA can be used to compare the earning generated by different companies. However, there are some significant limitations to the reliability of this metric that need to be considered, too.

The main challenge with using EBITDA as a financial measure is that it tends to inflate a company’s financials.

What makes EBITDA misleading is that it fails to account for many of the real expenses a business will be paying. Paying taxes and interest on debt or loans are a reality of running a company, and taking those out means you’re getting an inaccurate view of a company’s financial position.

Along with dismissing operating expenses, EBITDA doesn’t acknowledge the realities of depreciating assets either and the impact they can have on a company’s value.

When used in the process of evaluating a company’s financial position, EBITDA removes many of the expenses and costs associated with running that company. That means you’re receiving an inaccurate view of your company’s earnings that is likely much higher than it is in reality.

While EBITDA does present a number of challenges when it comes to accuracy, there are plenty of other financial metrics you can use to track your company’s earnings instead.

• Operating income: if you’re looking to understand your company’s profitability, operating income can be a more useful metric. It accounts for the revenue your company generates over a specific time period, minus any operating expenses.
• Service revenue: if you’re looking to segment out just the revenue generated from the services your company provides, service revenue can be a useful metric. It shows how much value your company is generating from providing services (not selling products) to your customers.
• Recurring revenue: particularly for SaaS businesses, recurring revenue can be a really useful metric for measuring recurring revenue from your customers, either on a monthly basis (MRR) or an annual basis (ARR).

While EBITDA is a way of measuring a company’s earnings, it tends to inflate your financial metrics to the point of inaccuracy. Although it can level the playing field when comparing the earnings of different companies, other revenue metrics (like recurring revenue and operating income) offer a more reliable picture of the financial position of your company.