There are many tools that business owners use to determine the financial success or profitability of their business, and one of those ways is referred to as “EBITDA.” EBITDA is an acronym for “Earnings Before Interest, Taxes, Depreciation, and Amortization.” In some contexts, it is used as an alternative to a business’s net income, but in general, its purpose is to measure the complete financial success of a business. Simply put, it is a form of valuation for small businesses.
Lenders look at a company’s ability to be profitable long-term, in addition to the company’s debt, operating expenses, the company’s performance, the company’s income statement, and other things that show the company’s cash flow.
Read on to learn more about why knowing your EBITDA is important when trying to get a small business loan.
What Do Banks Look for When Deciding On a Business Loan?
Traditional banks often have the same metric when it comes to what they look for in making a decision to give a business loan. This includes:
1. Credit scores
Credit scores between 640 and 700 are often considered good by lenders of business loans. The minimum credit score required for SBA loans and term loans is around 680. Business owners on the lower end of this range will likely need extremely strong business credentials to qualify, such as several years in business or large yearly sales showing an operating profit. If you don’t have either of those things, you won’t be able to qualify.
Also, if your personal credit score is lower than 699 but higher than 640, you may want to explore alternative loan sources in order to meet the funding requirements of your business. For borrowers with credit scores in this area, the best options for financing their equipment and medium-term loans will come from alternative lenders.
2. Financial statements
Financial and income statements are another factor banks use to determine if they want to give you a loan. Your company’s assets, liabilities, and capital must be shown on the balance sheet, and the most recent balance sheet is the one that is considered the most relevant as it identifies your business’s working capital. Ideally, your profit and loss statements should go back at least three years, although exceptions can be granted if you do not have sufficient history but do have strong credit and assets that can be pledged as collateral. You will also be required to show as much of a history of profits and losses as possible, going back as far as three years. Your income statement will show the total revenue of your business.
In addition, you may also be asked to produce current and past loans and obligations that have been incurred by your business, as well as the financial performance of all bank accounts, investments, credit cards, and supporting information such as tax identification numbers, addresses, and contact information.
If you’re a relatively new business, don’t fret. Banks can still offer you a loan, though they may request collateral. Therefore, in order for your company to qualify for a business loan, it must have tangible assets that can be used as collateral. When it comes to mitigating risk, financial institutions pay close attention to the assets in question.
For instance, if you intend to use your accounts receivable as collateral for a commercial loan, the bank will investigate the major receivable accounts to determine whether or not the companies that hold those accounts are financially stable. Additionally, the bank will only accept a portion of your receivables as collateral for the loan, typically between 50 and 75 percent of the total. When you receive a loan against your inventory, the bank will only take a certain proportion of the inventory, and they will go through a lot of hoops to make sure that it isn’t out-of-date merchandise.
What Is EBITDA and How Is It Calculated?
EBITDA stands for “Earnings Before Interest, Taxes, Depreciation, and Amortization” and is an operational term used to measure a company’s financial health. It can be used as a substitute for the total cash flow generated by the business.
There are two different approaches to calculating EBITDA by yourself. To get started, all you need is your financial statements—especially the income statement and the cash flow statement for the time period that you want to analyze. When it comes to monitoring performance, many businesses opt to calculate EBITDA on a monthly or quarterly basis. Those who are expecting a sale may also be required to compute it on an ad hoc basis in order to accommodate prospective purchasers.
Why and How Lenders Use EBITDA
Lenders might use EBITDA to look at your business’s past financial performance and trends. To counteract the effects of one-time or non-recurring capital expenditures, such as acquisition charges or the price of moving a facility, special adjustments are made. “Normalizing the EBITDA” is the term used to describe this procedure.
When it comes to a cash flow loan, lenders pay greater attention to a company’s EBITDA than when asset-based loan lenders. Cash flow loans rely heavily on the company’s future financial performance in order to be repaid by its lenders.
What Is the Debt to EBITDA Ratio?
The debt-to-EBITDA ratio shows how well your business can pay back its debts. If the ratio is high, it could mean that a company has too much debt. Banks will frequently specify a specific debt-to-EBITDA goal. For a business to qualify for a loan, it must maintain the agreed-upon level of debt, or else the entire loan might become due all at once. The debt-to-EBITDA ratio is a common metric that credit rating agencies use to determine the likelihood of a company defaulting on issued debt. Companies that have a high debt-to-EBITDA ratio may not be able to service their debt in an appropriate manner, which can result in a lower credit rating for the business.
Some EBITDA formulas that many companies use are:
1. EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
2. EBITDA = Operating Profit + Depreciation + Amortization
The outcome for both formulas will calculate the same number. Your EBITDA calculation can be done on your own, by a professional, or by using calculating software. Be sure that you also follow the generally accepted accounting principles (GAAP) when compiling your financial statements.
The GAAP is a compilation of authoritative standards established by the Financial Accounting Standards Board for the purpose of recording and reporting financial information. GAAP is designed to make the transmission of financial information more transparent, consistent, and comparable.
Example of EBITDA
Here’s a breakdown of how EBITDA would look based on the first formula method above:
|Provision for income taxes
|Net interest expense
|Depreciation and amortization
Measuring a business by EBITDA gives lenders better insight into your capital structures and operating income.
If you find that you need restructuring because you need to better understand how to establish business credit, or need financing options or small business startup loans, Nav can help you find what you need fast. Use our platform to instantly find your best options for business credit cards and small business loans based on your business data.
This article was originally written on June 27, 2022 and updated on September 6, 2022.
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