When a startup starts generating revenue, it cannot keep all of the revenue. There are several expenses a business must pay to keep it up and running. When these costs are deducted from the income generated, the remaining money is divided among the business shareholders.
The profit and loss account is proof of the income and expenses of a company that were expended in a certain period of time. At the top of the annual financial statements is the company’s turnover, and at the bottom is its net profit. Hence, the income statement is critical to understanding the difference between EBITDA and a company’s revenue. Each line of an income statement represents the money the startup has made in two different phases.
The difference between EBITDA and sales of a startup is essential for different purposes. While the former is a measure of a company’s profitability that can be used to measure a company’s efficiency, the latter is primarily the sole representative of company profits.
While the general public pays close attention to a company’s income, analysts, business owners, investors, managers, and moneylenders pay close attention to EBITDA. The metric helps determine how cash flow is generated from business operations, which in turn helps understand the business’s financial health and investment potential.
What are earnings?
A startup’s revenue is the total amount of money it generates from its business, without subtracting the costs associated with those sales. It is the sheer amount of money that the company makes.
Since income is a company’s main income from the sale of its products and / or services, no expenses are deducted from it. That’s why it’s at the top of every company’s income statement.
There are several sources a company can use to generate its income:
- Product sales
- Fee for services
- Commissions etc.
Other sources include dividends on the company’s own securities and interest on the money the company has borrowed. Thus, any money a company makes counts as its interest, which is usually reported once or three times a year.
In summary, revenue is the business the company generates (accrued income and cash) before accounting for expenses within a given accounting period. The other terms used to describe sales are income and gross sales.
Who uses the sales calculation?
The revenue calculation is mainly used by employees such as the chief financial officer, sales manager, and chief revenue manager. In addition, it is easier for the general public to measure a company’s sales as a benchmark than the metric EBITDA.
Formula and example for calculating sales
A company’s income can be calculated using the following formulas:
Income = total no. of consumers * Average price of the company’s services or products
Income = total no. Units sold * Average price of the company’s services or products.
For example, if a customer has a one-time annual contract with a company for $ 24,000, the monthly income is $ 2,000 and the annual income for that year is $ 24,000.
What is EBITDA?
It may seem like a technical or unfamiliar term, but like income, it is a metric used to measure a company’s earning power, i.e. its profitability. It is ‘E.arnings B.before IInterest, TAxles, D.Appreciation and AMortification. ‘
It is a tool more nuanced than sales for understanding a company’s ability to generate cash flow from its operations by adding the expenses indirectly related to the company’s operations to its net income.
Business costs such as depreciation and amortization are added back to sales as they are non-cash expenses. They are recognized as an expense in a company’s income statement, but do not need to be reported as money.
Taxes and interest, on the other hand, require cash payments but are considered non-operating expenses, which are unaffected by the main activity of the company. These are also added back to the metric.
Who Uses EBITDA?
This metric is often used to analyze business performance. Hence, it is mainly used by experts such as financial analysts, chief financial officers, accountants, business owners, and investors.
Why do companies use EBITDA?
Companies as well as analysts, investors and auditors prefer the metric over other tools because it only measures the operational profitability of a company. The costs that are deducted from income in order to evaluate it are directly related to the business of the company. These costs include rent, salaries, research and marketing costs borne by the company. Thus, the EBITDA primarily shows the operational efficiency and financial strength of a company.
Therefore, financial analysts and investors use the metric “Earnings Before Interest, Taxes, Depreciation and Amortization” to compare the operational health of companies with different capital structures.
Disadvantages of EBITDA
The metric does not qualify for the standard financial performance metric called GAAP, an acronym for generally accepted accounting principles. Due to the non-GAAP measurability, the calculation can vary widely from company to company.
When favoring EBITDA over sales, it is not uncommon for companies to emphasize the former over the latter. The former is more flexible and has the ability to distract financial professionals from critical problem areas on corporate statements.
In addition, investors need to keep an eye on companies as they begin to report EBITDA more clearly than ever. Such practices can essentially signal a red flag to investors as there may be instances where companies borrow large amounts of money or suffer rising development and capital costs. In such cases, earnings before interest, taxes, depreciation, and amortization can mislead investors in assessing a company’s real financial performance.
EBITDA is not a representation of cash income or the cost of assets. One major limitation is the assumption that a company’s profitability has a direct impact on sales and operations. It does not recognize the contribution and importance of assets and financing in maintaining a business.
The metric also excludes the cash required to maintain the company’s inventory and replenish working capital. In the case of a technology company, for example, the EBITDA calculation does not take into account the expenses associated with ongoing software development or the development of upcoming products.
While calculating the metric may seem simple enough, different companies use different amounts of profit when starting the metrics analysis. It tends to produce changing values in the financial statements. Even taking into account the anomalies resulting from taxes, interest and depreciation in the calculation, the results are not yet reliable.
- Disguises the company valuation
The worst of all disadvantages is the possibility of distorting the corporate image. Thanks to EBITDA, companies can appear cheaper than they are. When the metric’s stock price multiples are factored in, rather than net earnings, they result in lower multiples.
Formula and example for EBITDA
EBITDA is an estimated instrument that determines a company’s ability to generate cash flow from its business activities. Thus, the performance of the company can be measured by the metric.
EBITDA = (sales – expenses) + amortization + depreciation
It measures actual operating profit before business expense deductions and accounting.
More than one working formula can be used to derive a company’s earnings before interest, taxes, depreciation, and amortization. Another famous formula that is used starts with net income at the bottom of the income statement. The metric then adds the tax, interest, amortization, and depreciation entries to its numbers. So the formula is:
EBITDA = income + interest + taxes + amortization + depreciation
For example, if a company X had a net income of $ 200.00 and owed $ 30,000 in taxes, $ 10,000 in interest, $ 5,000 in amortization, and $ 7,500 in depreciation, then the numbers would be:
EBITDA = $ 200,000 + $ 10,000 + $ 30,000 + $ 5,000 + $ 7,500
= $ 250,000
Company X’s EBITDA for a given period would be $ 250,000.
Although cash is the lifeline of any business, revenue is more significant because it generates cash flow in businesses. But revenue and cash are not the same. One important difference is that a company’s revenue is the amount accrued while the reported cash amount is the amount received.
So when a company makes a sale, it is added to sales even without the customer paying. Since revenue is at the top of an income statement, its fluctuations can affect a company’s net income.
Business owners and accountants use EBITDA to compare their business situation with that of comparable companies. In addition to evaluating performance, it is beneficial for analyzing capital-intensive companies as they can take on large debts to sustain themselves.
Additionally, moneylenders and corporate investors prefer EBITDA over revenue for startup valuation. The former is less likely to be manipulated with finance and accounting methods. It also helps show financial status and cuts the factors over which managers and owners exercise discretion.
So, to answer the crucial question of why companies use EBITDA instead of revenue, the former is more successful at creating cash flow numbers. It is calculated by investors and lenders to predict how well a company will perform by paying for its expenses and maintaining or increasing its net income. The metric allows a company to be rated before it makes a sale.
When discussing EBITDA vs. sales, financial analysts attach importance to both parameters. Revenue is the net money a company generates, while EBITDA is the number at the end of a company’s financial statements. More specifically, the metric shows the total number of income and expenses – at the discretion of the owner – that represent a company’s ability to generate cash.
Because EBITDA does not qualify under GAAP, it may not be available on most of a company’s financial statements. But if it was on an income statement, it would appear well below the sales line.
Put simply, the main difference between a company’s EBITDA and revenue is that the former always appear lower than the latter on the income statement as operating costs such as cost of goods sold (COGS), general and administrative expenses (G&A). etc. are deducted from sales.