Adventures in strange acronyms - EBITDA
Dealing with Difficult People
nine. financial acronyms - EBITDA
Last week when sending the newsletter about CAPM (capital asset pricing model), a friend told me that it was a term they'd never encountered before. I thought it might be helpful to talk about some of the other acronyms that are commonly used in financial reports. To know EBITDA, you need some background information.
If you've ever read an annual report from an organisation that had financial numbers in it, you would see a couple of key documents, the income statement (or profit and loss) and the balance sheet. These documents are called financial statements because they represent the accountant of the company making a statement about the finances of the organisation. You might see some other documents around cashflows, but these two are the main ones you'll see.
One analogy that might be helpful is the difference between a film strip and an individual frame of film. The profit and loss is a bit like a film strip - the money that is going in and out of a business over a particular span of time. In an annual report, this would be all the money coming in and out over a 12 month reporting period: usually either a calendar year (January-December) or financial year (July-June). The balance sheet, by contrast, is more like a single frame of film: it represents all the money an organisation holds (and owes) at a given point in time (usually the last day of the reporting period).
When (as church treasurer) I was presenting a balance sheet to a congregation, one question I had was "why does this all add up to zero"? It's an excellent question. When a new entity is created with its own balance sheet, it's a document that shows the organisations resources, and the claims against those resources. These are classed into assets, liabilities and owner's equity. The owner brings some money into the organisation, and they're expecting to receive that back when the organisation closes. In the meantime, the money is used to create assets, and in some cases, the organisation will owe money to other entities, which would be liabilities.
Let's say the owner brings $1000 to the organisation.
Assets: $1000 (cash), Liabilities: $0, Owner's Equity: $1000.
The organisation buys some inventory, aiming to sell it at a profit.
Assets: $800 (cash) and $200 (inventory), Liabilities: $0, Owner's Equity: $1000.
They send out a bill for some of the goods sold: this is recorded as "accounts receivable". The excess is recorded as "retained earnings", as the total value of the enterprise has now increased.
Assets: $800 (cash), $100 (inventory), $500 (accounts receivable); Liabilities: $0, Owner's Equity: $1000, Retained Earnings: $400.
What might the liabilities be? They might owe money for some of the inventory they have acquired (accounts payable), or owe wages to their staff (wages payable) or have taken out a loan so they could grow (long-term loans). If they have staff for a while, they might take some leave at some point and need to be paid (provision for employee entitlements).
So that's the balance sheet: the individual frame of film that shows where an organisation is up to. How we get from one frame to another is the income statement (or profit and loss). This is where we show income and expenses.
If you're running an organisation with a simple buying something, then selling it at a profit, you would report on the sales revenue, minus the "cost of goods sold", to work out the net income for a period of time (the amount left over after you've bought the raw materials). This gives you your gross margin. From there, you show your operating expenses (eg staff costs, rent). This gives you your earnings before interest, tax, depreciation and amortisation (related to loans), or EBITDA which is one of the scarier acronyms you will encounter in learning about accounting.
Have you seen EBITDA before? Does it make a little more sense now? Hit reply to let me know.
Dave
Work. Study. Dad.