Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA)

What is EBITDA?

EBITDA stands for earnings before interest, taxes, depreciation, and amortisation. It measures how profitable a company is, not taking into account the way it finances its assets and the cost of capital items like machinery, buildings, and equipment.

EBITDA calculations can be made by applying figures from a company’s financial statements to the following formula:

EBITDA = Net income + interest + depreciation + tax + amortisation

Key takeaways:

  • EBITDA measures profitability excluding accounting deductions and financing costs
  • EBITDA allows the comparison of operational performances between companies and is used to determine debt servicing ability
  • EBITDA can be calculated using information from a company’s financial statements.

EBITDA and leveraged buyouts

Why is EBITDA important when there are other profitability measures? 

EBITDA is commonly used in leveraged buyouts, where a purchaser acquires a target company with mostly borrowed money. 

However, it’s the target company that takes on the heavy debt burden, rather than the purchaser. Since EBITDA shows profitability before financing and accounting deductions, it’s useful for assessing whether the target company earns enough to service future debt.

How to use EBITDA

EBITDA, by definition, excludes financial and capital expenditure from earnings, making it helpful for comparing the performance of similar companies that finance assets differently. 

However, it’s important to remember that using EBITDA in isolation to measure performance can be deceptive. 

For example, if a company has high debt, then net income as opposed to EBITDA would probably more accurately convey the risks facing the company, as well as its overall financial health. This is because net income takes into account financing costs.

The drawbacks of EBITDA

EBITDA is not covered by Generally Accepted Accounting Principles (GAAP), so companies might have different opinions on how to calculate EBITDA. Unfortunately, you can’t compare figures between companies if they’re determined using different approaches and assumptions. 

Here are some other drawbacks to bear in mind when using this metric to evaluate a company’s profitability.

Ignoring cost of assets

Using EBITDA as a performance measure overlooks the fact that financing costs and capital expenditure drive earnings, to an extent. Interpreting EBITDA’s meaning literally suggests only sales and operations are relevant to generating earnings.

Ignoring working capital

EBITDA also fails to reflect the working capital needs of a business. For example, a company with high levels of debt might show positive EBITDA, but after paying interest, it might have insufficient working capital to buy inventory.

Varying starting points

The lack of GAAP requirements also means companies can base their EBITDA calculations on different earnings figures.

Price to earnings ratio

A popular metric that investors use to help them decide whether to buy a company’s shares is the price-to-earnings (P/E) ratio

The P/E ratio measures a company’s share price relative to its earnings per share. This is a great metric for comparing different companies in the same industry or sector. 

Limitations of EBITDA

Given the drawbacks discussed, it’s clear that while EBITDA can provide a practical way to compare operating performances across companies and to evaluate debt servicing ability, it should not be used in isolation to assess profitability. 

EBITDA vs operating cash flow

As mentioned, EBITDA falls short in reflecting the working capital requirements of a business. Operating cash flow is a better indicator, since it takes into account cash coming in and going out through payables and receivables, and adds back non-cash expenses like amortisation and depreciation.

Comparison of companies using EBITDA

Let’s evaluate the performance of cake shops A and B. Identical in every way, A is partially funded by debt while B is funded by equity.

Cake shop A

  • Revenue = $5,000
  • COGS = $1,000
  • Interest ($3,000 at 10% interest) = $300
  • Depreciation = $500
  • Income before tax = $3,200
  • Tax at 30% = $960
  • Net income = $2,240

EBITDA = $2,240 + $500 + $300 + $960 = $4,000

Cake shop B

  • Revenue = $5,000
  • COGS = $1,000
  • Interest = $0
  • Depreciation = $500
  • Income before tax = $3,500
  • Tax at 30% = $1,050
  • Net income = $2,450

EBITDA = $2,450 + $500 + $1,050 = $4,000

The comparison accurately shows that from a pure operating performance perspective, both cake shops are exactly the same. However, cake shop B is more profitable in terms of net income because it does not have debt servicing costs.

The bottom line

EBITDA offers a quick way to determine the operating performance of a company and its ability to service debt. 

However, it should be used alongside other performance measures if you want an in-depth understanding of a company’s financial health.

Updated as of 10 November 2021. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.