What is EBITDA?
Definition: EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) is a financial metric used to evaluate companies operating performance.
The measure provides a clear view of the overall performance and often used as an alternative to earnings or net income.
Earnings Before Interest Taxes Depreciation and Amortization Explained
EBITDA, as a financial metric, focuses on the operating decision of a company, therefore, providing a clear idea on profit metrics before the impact of capital structure, leverage, and non-cash items. It differs from EBIT and EBITA on the fact that it strips all the costs of capital investments, such as expenses associated with debt.
Being earnings before other expenses are deducted, EBITDA has, over the years, allowed investors and analysts to determine companies’ ability to service their debts. Looking at EBITDA, it becomes much easier to determine a company’s ability to meet its heavier interest payments should it face restructuring as well.
EBITDA Formula
When it comes to calculating EBITDA, earnings taxes, as well as interest figures, are first taken from the income statement. In addition, depreciation and amortization figures as on the cash flow statement are also taken into consideration.
Conversely EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
EBITDA Example
Assume company ABC ended up with a net income amounting to $2 million in a given financial year. However, the company also incurred depreciation and amortization amounting to $1 million Interest expenses from loans borrowed totaled $2.5 million. The company also paid $2.5 million in taxes
EBITDA, in this case, will be
EBITDA= $2,000,000 + 1,000,000 + $2,500,000 + $2,500,000 = $5 million.
Interest is excluded from EBITDA, as it depends on the financing structure that the company agrees to. The fact that different companies have different capital structures often results in different interest expenses, thereby the exclusion.
Taxes are also excluded from EBITDA given that different regions come with different tax regimes Taxes are a function of tax rules, therefore, it does not provide a reliable way of assessing a management team’s performance or overall business performance.
Depreciation and amortization are other factors that vary significantly depending on the historical investments that a firm has made.
Why is EBITDA Analysis Important?
EBITDA, unlike other financial metrics, provides a clearer reflection to a company or business operations. By stripping out expenses, the metric makes it possible to ascertain whether a company’s operations are profitable. Earnings Before Interest Taxes Depreciation and amortization also tend to give A better picture of profit growth trends compared to other metrics.
Conversely, EBITDA is commonly used to compare companies operating within the same industry. By excluding expenses, it becomes possible to ascertain which company is profitable and likely to generate long term value. It is for this reason that the metric is commonly used in valuation ratios.
EBITDA is a more reliable financial metric as it allows investors to focus on a company’s baseline profitability by eliminating unhelpful variables such as interest, tax rates, depreciation, and amortization, which vary from one business to another.
What are some EBITDA Analysis Disadvantages?
One of the biggest tailwinds associated with EBITDA has to deal with the fact that it is not part of generally accepted accounting principles (GAAP). Likewise, it is not an acceptable measure of financial performance as per acceptable accounting practices.
EBITDA ignores the cost of assets, conversely assuming that profitability is a function of sales and operations alone. This is usually not the case as assets, as well as financing’ drive, play a pivotal role in companies turning in profits.
The fact that EBITDA is a non-GAAP measure means its value can vary from one company to another. For this reason, some companies often insist on EBITDA as it tends to distract from underlying problems within a business, such as spiraling debt levels.
Investors are often advised to watch out for companies that start reporting EBITDA all of a sudden. Such a move is often associated with increased debt levels that have taken a toll on net income. Similarly, it could be indicative of rising capital and development costs.
Summary
EBITDA is a financial evaluation metric that provides insight on performance as well as profitability. Buyers as well as investors rely on the metric to ascertain companies operating performance.