EBITDA stands for earnings before interest, taxes, depreciation and amortization. It’s a financial metric commonly used to evaluate a company’s financial performance and its ability to generate cash flow.
This post will cover EBITDA in detail, including what it tells you, when to use it to evaluate businesses, and its limitations.
What is EBITDA?
EBITDA is a financial metric used to evaluate a company’s operational performance and profitability. It measures a company’s earnings before accounting for interest expenses, taxes, depreciation, and amortization.
By excluding non-cash expenses like depreciation and amortization, as well as interest and tax costs influenced by a company’s capital structure, EBITDA aims to represent the earnings generated solely from the company’s core operations.
It’s important to note that EBITDA is not recognized by Generally Accepted Accounting Principles (GAAP) as a standardized financial measure. However, some public companies choose to report EBITDA in their quarterly results, often alongside adjusted EBITDA figures.
How to Calculate EBITDA
There are two formulas for calculating EBITDA:
EBITDA = Net Income + Taxes + Interest + Depreciations & Amortization
EBITDA = Operating Income + Depreciations & Amortization
To calculate EBITDA correctly, you need to understand every component of the EBITDA formula:
- Net Income: This is the company’s overall profitability after deducting all the expenses from the total revenue.
- Operating income: The amount of profit a company generates after deducting operating expenses.
- Interest: Interest expenses represent the cost of borrowing money. It can also represent interest earned. EBITDA excludes these expenses to focus solely on operating profitability, as interest costs can vary significantly based on a company’s capital structure.
- Taxes: These include income taxes paid by a company, such as federal, state, and local taxes.
- Depreciation and Amortization: Depreciation and amortization is the gradual decrease in the value of assets over time and writing off their initial cost. Depreciation is a non-cash accounting expense that reflects the allocation of the cost of tangible assets like buildings and machinery over their useful lives. Amortization is similar to depreciation but applies to intangible assets, such as patents and trademarks.
EBITDA vs EBIT
Both EBITDA and EBIT are measures of profitability of a company’s core operations. The key difference between EBITDA and EBIT is that EBITDA adds back the cost of depreciation and amortization while EBIT doesn’t.
Since EBITDA adds depreciation and amortization expenses back, it’s a more comprehensive measure of a company’s cash flow from core operations since it excludes non-cash expenses.
What Does EBITDA Tell You?
EBITDA offers a picture of a company’s core operating profitability. By excluding interest, taxes, depreciation, and amortization, EBITDA focuses on the earnings generated from day-to-day business activities. This makes it a useful measure to evaluate how well a company is performing in its primary operations.
EBITDA also serves as a proxy for a company’s ability to generate cash from its operations. It can be particularly relevant when assessing a company’s capacity to service debt, invest in new projects, or distribute dividends to shareholders. This is because EBITDA excludes non-cash expenses (depreciation and amortization) and financial charges (interest and taxes).
It also can be a key indicator of a company’s financial health. Lenders and investors often use EBITDA to assess a company’s ability to meet its debt obligations and its overall financial stability.
While EBITDA provides great insights into a company’s operating performance, some investors like Warren Buffet are skeptical about using this metric because it doesn’t consider capital expenditures.
When to Use EBITDA
EBITDA is a helpful tool when used correctly alongside other financial ratios like earnings per share. It helps business owners make smart decisions about where the company is headed. It’s also important for people who want to invest in or buy a company.
Here are common use cases for effectively employing EBITDA:
- Comparing companies: EBITDA is useful when comparing the operational efficiency and profitability of companies within the same industry or sector. It provides a standardized measure that allows for apples-to-apples comparisons.
- Assessing cash flow potential: EBITDA is a valuable metric to gauge a company’s ability to generate cash from its core operations. This is particularly relevant when evaluating its capacity to meet debt obligations or fund future investments.
- Identifying Trends: EBITDA can help reveal trends in a company’s core operations over time. Analyzing changes in EBITDA can provide insights into the business’s performance and potential areas for improvement.
- Business valuation: Businesses can be valued by an EBITDA multiple, where a company’s EBITDA is multiplied by a specific factor to estimate its overall value. This approach helps assess a company’s worth in terms of its ability to generate cash from its operations, making it a key factor in determining a fair price for the business in sales, acquisitions, or investment transactions.
Limitations of EBITDA
While EBITDA is a useful financial metric for assessing a company’s operational performance and cash flow potential, it has several limitations.
For one, EBITDA is not a standardized metric under Generally Accepted Accounting Principles (GAAP). Companies can manipulate it by choosing what to include or exclude, making it challenging to compare EBITDA figures between companies.
Another drawback is that EBITDA doesn’t account for the working capital needs of a company, which are essential for maintaining and growing a business. For instance, a company may need to reinvest in its operations, and EBITDA doesn’t consider the cash required for this. It also doesn’t capital expenditures and taxes.
Finally, EBITDA calculations can be misleading when assessing the financial health of distressed companies. This is because it doesn’t consider the challenges they may face in servicing debt or overcoming operational difficulties.
EBITDA is a proxy for a company’s cash generating potential. However, you shouldn’t rely on it solely as it doesn’t take into account all of the company’s expenditures including interest, taxes, capital expenditures, and working capital.
EBITDA is commonly used for business valuation, financial leverage analysis, and more. TIKR makes this easy by calculating EBITDA for 100,000+ companies globally. Get started on TIKR.com for free today!