The Motley Fool

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 costs of capital items like machinery, buildings and equipment.

EBITDA calculations can be done by applying figures from company 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 comparison of operational performance between companies and is used to determine debt service 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 who 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 the impact of 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, for a company with heavy debt burden, net income which takes into account financing costs would probably convey more accurately the risks facing the company and its overall financial health.

The drawbacks of EBITDA

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

The following are other drawbacks to bear in mind when using this metric to evaluate company 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 may show positive EBITDA, but after paying interest, it has 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.

Obscuring company valuation

A popular metric, investors often use the Price-Earnings (P/E) ratio to decide whether to buy a company’s shares. However, using EBITDA as denominator when calculating the P/E ratio of a stock often leads to a lower multiple, suggesting the current stock price is low relative to earnings. Yet the stock is not necessarily a bargain — you might find the multiple to be much higher if you use operating profit or net income instead of EBITDA.

Limitations of EBITDA

Given the drawbacks discussed, it’s clear that while EBITDA can provide a practical way to compare operating performance across companies and evaluate debt service ability, it should not be used in isolation to assess profitability. EBITDA is not covered by GAAP, ignores capital expenditure and financing costs, and can lead to misleading company valuations.

EBITDA vs. EBIT and EBT

EBIT is often referred to as operating income, and is calculated using the formula:

EBIT = net income + interest + tax 

EBT on the other hand, measures performance, taking into account financing costs of the company but not its tax obligations. It’s calculated as:

EBT = net income + tax

EBITDA vs. operating cash flow

As mentioned, EBITDA falls short in reflecting 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 you add back non-cash expenses like amortisation and depreciation.

Comparison of 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 its financial health.