An introduction to EBITDA
EBITDA stands for earnings before interest, taxes, depreciation, and amortisation.
It measures profitability from a company's core operations. EBITDA does this by excluding non-cash depreciation and amortisation expenses, as well as taxes and the costs of debt (which depend on the capital structure). Essentially, it removes the factors that business owners have discretion over, such as capital structure, financing, depreciation methods, and taxes (to an extent).
Most companies report EBITDA in their financial statements as it is a measure of operating performance.
- EBITDA measures profitability, excluding the costs of financing and asset depreciation
- The metric allows the comparison of operational performances between companies and is used to determine debt servicing ability
- We can derive EBITDA from a company's financial statements.
There are two ways to calculate EBITDA:
EBITDA = Net income + interest expense + taxes + depreciation + amortisation
EBITDA = Operating profit + depreciation + amortisation
Net income is revenue minus all the expenses and costs of generating that revenue, including selling, administrative, and operating expenses, depreciation, interest, taxes, and other costs.
Operating profit is the total earnings from the core business without the deduction of interest or taxes. Operating income does not include taxes or interest expenses, so adding these back to calculate the EBITDA is unnecessary.
The two formulas may give different EBITDA results depending on what items a company includes in its net income. For example, it may include one-off income or expense items in the net income but not the operating profit.
How to use EBITDA
EBITDA, by definition, separates earnings from the company's capital structure, making it helpful for comparing the performance of similar companies that finance assets differently.
It measures a company's operating performance and is commonly used as a proxy for cash flow. Multiplying EBITDA by the relevant multiple for its industry can provide an indicative valuation of a company. The metric can also be used to evaluate companies not generating a net profit.
By looking at EBITDA, you can determine the underlying profitability of a company's operations, allowing for comparison to other businesses. Using those results, you can gain a deeper understanding of the impact of capital structure and differences in taxes (particularly if companies operate in different countries) on actual profits and cash flows.
However, it's important to remember that using EBITDA in isolation can be deceptive. For example, if a company has high debt, then the net income, as opposed to EBITDA, would probably more accurately convey the company's risks and overall financial health. This is because net income considers financing costs, such as a company's interest payments.
Likewise, EBITDA does not capture the cost of maintaining and sustaining a company's assets and equipment. This can be relevant when a company has a large amount of depreciable equipment.
At the end of the day, all expenses excluded from EBITDA (such as taxes) still have real-life financial implications that should not be ignored.
Variations of the metric
There are several variations to EBITDA that investors can use to help build a picture of the value of a company.
- EBIT = Earnings before interest and taxes
- EBIAT = Earnings before interest and after taxes
- EBID = Earnings before interest and depreciation
- EBIDA = Earnings before interest, depreciation, and amortisation
- EBITDAR = Earnings before interest, taxes, depreciation, amortisation, and rental costs
- EBITDARM = Earnings before interest, taxes, depreciation, amortisation, rental costs, and management fees.
Some have criticised the use of these metrics, claiming they can be easily distorted and do not provide an accurate picture of cash flow. They also ignore the impact of actual expenses, such as fluctuations in working capital.
What is the EBITDA margin?
Analysts often use EBITDA to calculate a company's EBITDA margin. This is a valuable financial metric because it allows you to compare the relative profitability of companies of different sizes.
To calculate the EBITDA margin, divide EBITDA by total revenue. The higher the EBITDA margin, the lower the company's operating expenses relative to its revenue. A company with a high EBITDA margin is more efficient and likely to be more profitable overall because it generates high EBITDA while keeping operating expenses low.
Comparing companies using EBITDA
Let's evaluate the performance of two companies: Company A and Company B. Identical in every way, A is partially funded by debt while B is funded by equity.
- Total revenue = $5,000
- Cost of goods sold = $1,000
- Interest ($3,000 at 10% interest) = $300
- Depreciation = $500
- Income before taxes = $3,200
- Tax at 30% = $960
- Net income = $2,240
EBITDA = $2,240 + $500 + $300 + $960 = $4,000
- Total revenue = $5,000
- Cost of goods sold = $1,000
- Interest = $0
- Depreciation = $500
- Income before taxes = $3,500
- Tax at 30% = $1,050
- Net income = $2,450
EBITDA = $2,450 + $500 + $1,050 = $4,000
The comparison shows that both companies are the same from an operating performance perspective, with identical EBITDAs. However, Company B is more profitable in net income than Company A because it does not have debt servicing costs.
EBITDA vs operating cash flow
EBITDA falls short when it comes to reflecting the working capital requirements of a business. Operating cash flow is a better indicator because it accounts for cash coming in and out through payables and receivables and adds back non-cash expenses like amortisation and depreciation.
Operating cash flow has two other advantages over EBITDA. Firstly, it is included in a company's cash flow statement, so no calculations are required by the financial analyst. Secondly, it is covered by the generally accepted accounting principles (GAAP), meaning there are prescribed ways that a company must present its operating cash flow. This means it is directly comparable across different companies.
What are the drawbacks?
GAAP does not cover EBITDA. This means there is no universally prescribed way for companies to calculate EBITDA if they show it as a metric in their financial reports. Some companies may exclude specific one-off or non-recurring items on their income statements from their EBITDA calculations.
The fact that companies might have different approaches to calculating EBITDA does present a major drawback. It's difficult to compare figures between companies if they're calculated using different assumptions and methodologies.
Here are some other drawbacks to consider when using this metric to evaluate a company's profitability.
Ignoring the cost of assets: EBITDA overlooks the fact that financing costs and capital expenditure are significant elements driving company earnings. EBITDA can give the erroneous impression that only sales and operations are relevant to generating revenue.
Ignoring working capital: EBITDA fails to reflect the working capital needs of a business. Working capital is a measure of the financial health of a company. It is the difference between its current assets (like cash and inventory) and liabilities (like short-term debt). Positive working capital means the company has the liquidity to grow its business.
Because EBITDA doesn't consider financing costs, it can sometimes give an incomplete picture of a company's short-term financial health. For example, a company with high debt levels might show positive EBITDA, but after paying interest, it might need more working capital to buy new inventory or finance its ongoing operations.
Varying starting points: The lack of GAAP requirements means companies can base their EBITDA calculations on different earnings figures. As we have shown, there are at least two ways to calculate EBITDA, and they can give different answers depending on the company in question.
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, analysts should not use it in isolation to assess profitability. However, EBITDA can still deliver valuable insights when used with other financial metrics, like a share's price-to-earnings (P/E) ratio.
The bottom line
EBITDA offers a quick way to assess a company's operating performance and its ability to service debt. It can be readily calculated using items from a company's income statement.
However, you should use EBITDA alongside other performance measures if you want an in-depth understanding of a company's true financial health and overall financial performance.