Net income vs EBITDA: Key differences to know

Key difference between net income and EBITDA

The key difference between net income and EBITDA lies in what numbers are included in the calculation of each metric. Net income, often referred to as the bottom line, accounts for all expenses including taxes, interest, depreciation, and amortization. 

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) strips out these costs to focus purely on operational profitability before the impact of financial strategies and accounting decisions.

This makes net income a more precise measure of profitability and EBITDA a better showcase of a business’s daily operations and cash flow.  We’ll get more into the practicality and use cases of each below.

What is EBITDA?

EBITDA is a measure of a company's profitability. The higher the EBITDA, the more profitable the company will likely be.

It stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. EBITDA is closely related to EBIT (earnings before interest and taxes), adjusted EBITDA (a normalized EBITDA), and cash-adjusted EBITDA (which adds deferred revenue to predict a company's future EBITDA).

Earnings

Earnings are generally going to be net income. You can read your company's net income right off the income statement or statement of cash flows.

Check out the net income section of this post for more info on net income.

Interest, taxes, and non-core business operations

Interest and taxes are non-core business expenses that you add to net income (or earnings) to get EBIT. (You'll get EBITDA once you add depreciation and amortization figures.)

A business can incur an interest expense on anything it's borrowed. Here's a non-exhaustive list of financing costs that incur interest:

• Bonds
• Loans
• Convertible debt
• Mortgages
• Lines of credit

Likewise, taxes are costs imposed by the government that a business is obligated to pay. 

Here's a non-exhaustive list of common taxes businesses are expected to pay:

• Income taxes (sometimes called corporation taxes)
• Sales tax (sometimes called VAT, value-added tax)
• Property taxes
• Excise taxes
• Employment taxes
• Dividend tax
• State income taxes
• Federal income taxes
• Local taxes

It's worth noting that a company's income tax expense is among its higher taxes. These non-operating expenses all get added to earnings when calculating EBITDA.

What is EBITDA vs. EBIT? 

EBIT is EBITDA without depreciation and amortization added.

Here's the formula:

EBIT = net income + interest + taxes

That would be all there is to it...but it turns out that EBIT is used more than EBITDA in certain financial ratios.

For example, the EBIT margin, interest coverage ratio, fixed interest coverage ratio, fixed charge coverage ratio, times interest earned ratio, and financial leverage ratio all use EBIT.

But the only ratios that used EBITDA are the EBITDA multiple (also called the EV:EBITDA ratio) and the earning multiple. For most companies, EBITDA will be higher than EBIT, so CFOs prefer to report EBITDA. But it's worth looking at both.

What are depreciation and amortization?

Depreciation and amortization expenses represent the loss of value of an asset. A depreciation expense is a loss of an asset's value over time. An amortization expense is the method used to decrease the asset's cost over time.

So depreciation deals with value, while amortization deals with cost. But what does that difference look like in practice? 

Depreciation deals with physical equipment: the value of a car decreases with age. That's depreciation.

Amortization deals with intangible assets, like customer lists. A list of potential customers in a company with a small target market (such as an ABM SaaS company) gets less valuable over time because it becomes more inaccurate (new potential customers are created, people change jobs, and so on).

If you think of amortization as "depreciation, but for intangible assets," you're probably okay.

How to calculate EBITDA

Here's a simple formula for calculating EBITDA:

EBITDA = Earnings + Interest expense + Tax expenses + Depreciation expenses + Amortization expenses.

Interpreting EBITDA 

Now that you know what goes into EBITDA, how do you interpret it? 

Fortunately, EBITDA is easy to interpret. A higher EBITDA is better. 

Higher in comparison to what? Well, in comparison to this company's past performance. (If you want to use EBITDA to compare one company's financial performance to another, you should use adjusted EBITDA. More on that in a second.)

A year-on-year growing EBITDA is a good indicator of a company's financial health. It indicates gross profit increases, revenue growth, higher net earnings, and more. Of course, you can always supplement EBITDA with cash-adjusted EBITDA as a more realistic way to forecast operating profits.

Let's break down each of those terms a little more.

How does EBITDA determine business valuation?

Both EBITDA and net income play a big role in business valuation, but EBITDA is becoming increasingly important.

In this section, we'll explain why EBITDA is so important for determining the valuation of a company.

EBITDA margin 

EBITDA margin, also known as the enterprise value (EV) to EBITDA ratio, is a financial ratio that shows how desirable a company is as an acquisition target.

Here’s a formula for how to calculate EV:EBITDA ratio:

EV:EBITDA ratio = EV ÷ EBITDA

You can calculate EV by adding market capitalization to debt and subtracting cash and cash equivalents.

So the question becomes: Do you use EBITDA, adjusted EBITDA, or cash-adjusted EBITDA?

And the answer is: it depends.

To look like a more desirable acquisition target, you want to use adjusted EBITDA. This is usually higher than normal EBITDA, so the resulting ratio will be lower. A low EBITDA margin suggests stock is undervalued, which makes a company a low risk for acquisition.

However, this is tantamount to selling at a discount. If you're trying to squeeze as much money out of an acquisition as possible, using plain EBITDA---a smaller denominator---will give you a higher EBITDA multiple.

Valuation multiples 

To get your company's valuation, simply multiply its EBITDA by its EBITDA multiple.

Here's a list of common EBITDA multiples by industry for Fortune 500 companies in the United States.

EBITDA example 

Here’s a practical example of how EBITDA can be interpreted and applied:

Consider a manufacturing company evaluating its performance over the last three years. In year 1, the EBITDA was $500,000; in year 2, it rose to $600,000, and in year 3, it reached $700,000. 

This consistent increase in EBITDA indicates improved operational efficiency and increased revenue, suggesting that the company's management strategies are effective. Comparing these figures year-on-year allows stakeholders to assess the company's financial health beyond just its net earnings.

Advantage of EBITDA 

Here are some key advantages to using EBITDA:

• Operational focus: Reflects a company's ability to generate revenue by excluding non-cash expenses like depreciation and amortization.
• Simple calculation: Can be quickly calculated from the income statement by adding back interest, taxes, depreciation, and amortization to net income.
• Valuation metric: Useful in financial ratios, such as the EBITDA multiple, to assess company valuation.

Limitations of EBITDA

Here are some key limitations when using EBITDA:

• Non-GAAP metric: Not standardized under GAAP, which allows for creative accounting practices, potentially leading to misleading representations.
• Excludes key costs: The exclusion of key capital expenditures like interest, taxes, depreciation, and amortization can lead to overstating earnings.
• Ignores debt: Fails to reflect the cost of debt, which can distort the assessment of financial health, especially in highly leveraged companies.
• No direct cash flow insight: Provides no direct insight into actual the cash flow of the business, requiring further analysis to understand if the business is profitable.

What is net income?

Net income—sometimes called net profit, net income earnings, or just earnings—is the difference after all expenses have been subtracted from revenue.

Here’s a simple formula for calculating net income:

Net Income = revenue - expenses

The important thing to remember is that net profit is a "bottom-line" item. It's synonymous with both a company's profit and that company's total earnings.

Where is net income on the cash flow statement?

Net income is carried over from the income statement to become the first item on the cash flow statement. You can read net income from your company's financial statements.

Cost of Goods Sold (COGS)

Cost of Goods Sold (COGS) is the cost it takes to make a sale. This includes the cost of acquiring, preparing, and storing inventory but not the cost of marketing, selling, or distributing.

Salaries are included in COGS if they're directly related to making a product. For example, you'd include payroll for the engineering team in a SaaS company's COGS, since that's the cost of preparing the product.

(Indirect expenses like the salaries for administrative workers, bookkeepers, and marketing are generally part of SG&A.)

COGS is important because you subtract it from your revenue to get your gross income.

Operating expenses

Operating expenses (OPEX) are anything that the business needs to spend money on to run.

Here's a non-exhaustive list of common operating expenses:

• Rent and utilities
• Equipment and software
• Inventory
• Sales and marketing
• Payroll
• Insurance
• Step costs
• Research and development

Operating expenses differ from capital expenditures (CAPEX) because CAPEX are investments.

Some examples of non-operating expenses are interest charges (and other costs of borrowing) and losses on the disposal of assets.

In other words: most of what you add back to net income to get EBITDA.

It's important to know about operating expenses because subtracting them from top-line revenue is important for accurately depicting your company's net income.

CAPEX are investments.

Some examples of non-operating expenses are interest charges (and other costs of borrowing) and losses on the disposal of assets.

In other words: most of what you add back to net income to get EBITDA.

It's important to know about operating expenses because subtracting them from top-line revenue is important for accurately depicting your company's net income.

Net income example 

Here’s a practical example of how net income can be interpreted and applied:

In one fiscal year, a hypothetical retail company generates $1 million in revenue. The COGS, including direct materials and labor costs, amounts to $600,000. The company also incurs $200,000 in OPEX, which includes rent, utilities, and payroll for non-manufacturing staff. 

After subtracting both COGS and OPEX, the company's net income is $200,000. 

$1,000,000(revenue) - $600,000(COGS) - $200,000 (OPEX) = $200,000 (net income)

This shows how useful net income can be as a measure of true profitability.

Benefits of net income

Here are some key benefits to net income: 

• Clear profitability indicator: Provides a definitive measure of profitability after all expenses, giving a clear bottom-line figure that indicates financial success or failure.
• GAAP metric: Meets regulatory compliance since net income is required in financial reporting.
• Investor insights: Offers investors a straightforward metric to assess the company's profitability and potential for dividends.

Drawbacks of net income

Here are some key drawbacks to net income: 

• Influenced by non-operational items: Net income can be heavily influenced by non-operational items like interest expenses or one-time gains and losses, which might skew the true operational performance.
• Depreciation impact: Depreciation methods can affect net income significantly, introducing variability based on accounting choices rather than actual cash flow changes.
• Short-term focus: Focusing on net income might encourage short-term decision-making at the expense of long-term value creation, as managers might cut essential investments to improve the reported profit.

EBITDA vs. net income: Key differences

The key difference between EBITDA and net income? EBITDA is net income BEFORE taking out interest, tax, depreciation, and amortization expenses. So EBITDA will almost always be higher than net income.

Use cases

EBITDA is frequently used in industries like SaaS and other high-growth sectors to highlight earning potential without the noise of non-operational costs that can obscure the underlying performance. 

Net income is universally used across all industries and is a critical component in calculating Earnings Per Share (EPS), providing a clear measure of profitability after all costs have been accounted for.

Usage of depreciation and amortization

In the calculation of net income, depreciation and amortization are significant because they are deducted as expenses, which lowers the reported profit. 

EBITDA, however, excludes these expenses, offering a view of earnings that focuses purely on operational performance without the influence of these non-cash deductions, thereby typically presenting higher figures than net income.

Ease of calculation

EBITDA is considered simpler to calculate since it requires fewer adjustments to earnings than net income. This simplicity allows EBITDA to be used effectively for day-to-day operational assessments, as there’s no need to account for the complexities of tax percentages or non-tangible factors, such as the remaining years on a copyright.

How do you convert EBITDA to net income?

Converting EBITDA to net income is easy and has to do with the formula for EBITDA. Recall that EBITDA = net income + interest + tax + depreciation + amortization.

So deriving the formula for net income is easy. Just take out all the stuff that's been added in.

Net Income = EBITDA - interest - tax - depreciation - amortization

The bottom line on net income vs. EBITDA

Now that we understand the difference between EBITDA and net income, you can more effectively evaluate the operational health of your company—beyond just its net profits—and apply these insights to optimize investment strategies and enhance stakeholder communications.

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