Earnings before interest, tax, depreciation and amortisation (EBITDA) is a financial metric that helps calculate a company’s financial performance and cash flow. EBITDA is a precise calculation of financial performance because it shows earnings before financial and accounting deductions.
What Is Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)?
EBIDTA is the acronym for Earnings Before interest taxes depreciation and amortization. It is instrumental in determining a company’s overall financial performance. It is a measure of a widely used metric that companies use to measure performance with respect to industry average and competitors. It is a good way to measure the core profit runs but it can be misleading at times as it excludes the cost of capital investments like land. It is sometimes used as an alternative to net income and is a more precise measure of analysing performance because it shows earnings before deductions are made (accounting and financial).
It’s not mandatory for companies to disclose their EBITDA legally. It can be worked out using the information provided in the company’s financial statements (as the earnings, interest and taxes are available in the company’s income statement whereas depreciation and amortization are found in the notes to operating profit or in the cash flow statement).
Understanding EBIDTA
EBIDTA is an earning metric that does not include the different ways in which a company may use debt equity cash or other capital resources to fund its operations. It does not include depreciation and taxes (as the former may not reflect a company’s ability to generate capital whereas the latter can vary from time to time and is affected by multiple conditions which are not directly related to a company’s operating results).
While it is not considered part of the generally accepted accounting principles by the SEC but SEC requires that companies that register securities reconcile EBITDA to net income. It is a handy tool for normalising a company’s performance results which makes evaluation easy and quick.
It is a useful formula for companies to check their long-term growth potential and showcase it to the investors so they can easily compare it with existing businesses but if misused it can be used to show that a company’s earnings are greater than they are.
Negative EBITDA generally represents poor cash flow but a positive one doesn’t always mean that the business has high profitability so you need to check and make note of the factors that have been excluded or included while calculating EBITDA.
Components of EBITDA
- Earning Earning simply refers to the money a company has earned over a certain period. It can be calculated by simply subtracting the operating expenses from the total revenue of the company.
- Interest This component refers to all the expenses related to borrowing and financing through debt (companies finance their projects by issuing stocks or borrowing money both of which involve interests).
- Taxes Ebitda does not include taxes while calculating the company’s earnings.
- Amortization It is the expense related to the eventual expiration of intangible assets like patents.
- Depreciation Depreciation represents the decrease in the monetary value of tangible assets as time passes. It includes assets like cars, machines etc.
The formula for calculating EBITDA
There are two ways in which you can calculate EBITDA for understanding the company’s potential growth.
- Using operating income EBITDA = Operating Income + Depreciation + Amortization
EBITDA is calculated by adding operating income depreciation and amortization. Operating income is the profit made by the company (obtained after deducting operating expenses, i.e. the cost of running the daily business) It helps the investors segregate the earnings from the company’s operating performance by excluding interests and taxes.
- Using net income The formula for calculating EBIDTA using net income is: EBITDA = Net Income + Taxes + Interest Expense + Depreciation + Amortization
This formula is used in net income and adds it back to the taxes, interest expenses, depreciation and amortization to find the operating income.
Importance of a good EBIDTA
A good EBIDTA helps companies get funds and analyse its potential growth in the near future. It generally means that the company is doing well in a particular sector when compared to its competitors or peers. It is not rewarded or punished for the same.
Limitations of EBIDTA
While EBITDA is an important metric there are certain limitations and drawbacks to it. First and foremost, it does not fall under generally accepted accounting principles (GAAP) as a measure of financial performance. This is because its calculation can vary from company to company depending on the factors used. Some companies use this loophole to highlight EBITDA over net income as it is more flexible and try to cover up the problems in their financial statements.
This is a very important red flag for investors as EBITDA can not be solely relied on when they want to analyse the company’s performance as it can be misleading at times. They might want to look out for companies that suddenly start highlighting EBITDA when they were doing so in the past. It can indicate heavy borrowings or issues in raising capital due to high development costs.
Here are some other drawbacks of EBITDA:
Exclusion of monetary value of assets There is a common misconception that EBITDA represents cash earnings but it ignores the cause of assets which is a crucial factor for determining cash earnings. It goes on to include only the profit as a function of sales and operation as if the assets and finance provided to the company do not hold any value.
Exclusion of working capital Yet another factor that seems to be missing from it is the working capital and the replacement of old equipment. It includes the profit made by selling a product but does not include the inventory required to fill its sales channels. In the case of a software company, EBITDA does not include the cost involved in developing the software versions, its maintenance or the upcoming products.
Dynamic starting points While the formula may seem to be simple enough (as it only involves excluding the interest payments, tax charges, depreciation and amortization from the total earnings) but there can be different earning figures which can be used as the starting point for EBITDA. This means that one can use any earning as an initial point which makes EBITDA susceptible to the earnings accounting games found on the income statement. While it is possible to account for the distortions that result from these excluded factors, the final result might still be unreliable.
Obscures company valuation The last limitation is that EBITDA can make a company look less expensive than it is. It obscures or hides the company valuation so when the analyst looks at the stock price multiples of the EBITDA instead of the bottom-line earnings, they produce lower multiples. Take the historic example of the telecom operator, Sprint Nextel whose stock was trading at 7.3 times its forecast EBITDA on 1st April 2006. The company traded at 20 times higher (as a multiple of forecast operating profits) and 48 times its estimated net income which is highly misleading and masks the real worth of the company.
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