EBITDA explained

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What is EBITDA

Readers who regularly follow the latest financial news will undoubtedly have come across the term EBITDA. Yet, what is it and how is it calculated? Why is it important, who uses it and when is it useful? How is EBITDA used in company valuations? In what follows we will try to answer all these questions and more.

What is EBITDA?

The term EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. EBITDA is a way to measure a firm’s profitability as well as its financial and operating performance. It is used as an alternative to similar metrics such as net income, earnings, or revenue.

Many investors choose to use EBITDA since it places the focus directly on the financial results of operating decisions by eliminating the role played by non-operating costs. The argument is that a new management team might be able to improve performance by making different decisions regarding interest payments, tax rates, depreciation, and intangible assets. It provides a ‘cleaner’ figure that is a better indication of the firm’s operating profitability. This makes it easier for investors, buyers, and owners to make comparisons between companies.

How is it calculated?

EBITDA can be calculated in two different ways:

  1. Start with net profit and add back interest, taxes, depreciation, and amortization. or
  2. Start with operating income but this time just add back depreciation and amortization.

Interest

This is basically the financing cost of a firm’s debt. Since it’s such an important figure, it typically appears separately on a firm’s income statement. If that is not the case, it can be calculated by using a debt schedule that sets out all the debts that appear on the firm’s balance sheet. EBITDA removes interest payments because the capital structures of different businesses are not the same and therefore they don’t have the same expenses in respect of interest.

Tax payments

Tax payments are also removed during the EBITDA calculation process. This is because these amounts do not actually have much to do with a firm’s performance. On top of that, taxes vary from one geographical region to the next. Like interest, taxes are eliminated to offer investors a more uncluttered picture of the firm’s real financial performance.

Depreciation

Depreciation refers to the drop in the value of an asset during a given time period. It is a non-cash expense that does not directly affect a firm’s operating income, which explains why it is removed.

Amortization

Amortization refers to an accounting technique by which the book value of intangible assets is written off over a fixed period of time. It is a fairly standard practice to report amortization costs (if there are any) on a firm’s financial statements. The following are examples of intangible assets: goodwill, trademarks, and patents.

Although it does have a negative impact on profits, it does not have any effect on cash flow. This means that it is not a cash expense. EBITDA only concerns itself with a firm’s cash flow. Thus it makes sense to remove amortization costs from the equation when we want to calculate a firm’s true value. Regardless of which of the two formulas is used, all the information one needs to calculate it can normally be found on a firm’s balance sheet, provided it keeps accurate financial records.

Note that even the smallest error in one of these values could make the resulting EBITDA calculation useless. It could cause profitability to be undervalued or overvalued.

Why is EBITDA important?

Calculating and knowing how to properly use EBITDA is important to investors, business owners, and financiers for one important reason. It gives all these interested parties a better picture of the firm’s real value. EBITDA makes it easier to study and compare the profitability of different businesses. It removes the impact of accounting or government and financing decisions. This gives a raw (but clearer) picture of a firm’s true earnings.

EBITDA has for all practical purposes become the de facto metric used. This is why private equity investors, professional buyers, and business owners are discussing business valuations using EBITDA. It is also often used instead of the standard cash flow metric.

Who uses EBITDA?

Business Owners

Business owners can use EBITDA to help them compare the profitability of their business compared to similar firms in the same or other industries.

Retail Investors

Retail investors often use this metric to assist them during the valuation of a company they consider buying or investing in.

Financial Industry Professionals

Finance providers often use the EBITDA formula to get a better understanding of the real profitability of a business enterprise that is applying for a loan or other form of finance. This helps them to gain a better understanding of the firm’s ability to pay back these debts.

Financial analysts often use the EBITDA metric when they are trying to determine what truly drives value for a particular business and to help them make profit projections for the future. A firm’s management might find EBITDA useful to get a better idea of its value and to demonstrate this to prospective investors.

Investment bankers typically turn to EBITDA if they want to eliminate the impact of accounting and financing decisions on a firm’s operating performance because it enables them to get a clearer view of its ability to repay debt and increase operating efficiency and/or top-line revenue.

Private Equity

EBITDA is also useful during the valuation of private businesses that are not listed on any stock exchange. When a business is not generating a profit, EBITDA is one of the best metrics one can use if you want to evaluate it and compare it to similar businesses in the same industry. This is one of the reasons why private equity firms often use EBITDA. In fact, EBITDA first became prominent during the 1980s when leveraged buyout investors were looking for a way to examine distressed businesses that were in need of financial restructuring.

They found EBITDA particularly useful if they wanted to quickly calculate whether or not a specific company would be able to afford the interest and redemption payments on such a financing deal over the near term.

Example of how EBITDA can be used

Let’s take the example of a manufacturing firm that generates $50 million in total income. The firm’s production costs amount to $20 million and its operating expenses amount to $10 million. The total amount of amortization expenses and depreciation is $5 million. The company pays interest of $2.5 million on its debts. This leaves earnings before taxes of $12.5 million. If we deduct taxes of 20% ($2.5 million) from that, net income amounts to $10 million.

To calculate EBITDA we add back interest ($2.5 million), tax ($2.5 million), depreciation and amortization ($5 million). The final figure for EBITDA equals $20 million.

EBITDA versus net income

Why not use the trusted metric of net income instead of EBITDA? The reason that supporters will often cite is that net income reflects a firm’s business earnings after all expenses. These include interest, tax, depreciation, and amortization cost deductions. As such it is regarded as a wider view of a firm’s profitability.

Since many businesses, however, use non-cash expenditure like amortization and depreciation to reduce their tax liability, net income is typically not the best reflection of a firm’s real cash flow potential.

EBITDA compared to operating cash flow

If one is looking for a measure of the real amount of cash a particular business is generating, operating cash flow actually beats EBITDA on a number of fronts. In the first place, it also adds non-cash expenses such as amortization and deprecation back to the firm’s net income.

Secondly, however, it goes further and also reflects changes in working capital that either provide or use cash. For example changes in inventories, payables, and receivables. If the aim is to determine the amount of cash a business is generating, the above-mentioned working capital factors are of key importance.

If investors should rely completely on EBITDA without including increases or decreases in working capital, they might well fail to pick up clues that indicate whether a firm is experiencing cash flow problems because it is failing to collect on its accounts receivable.

What can be regarded as a good EBITDA?

Since EBITDA is a way to calculate a firm’s profitability and financial performance, the higher it is the better. Businesses of different sizes that are operating in different industries and sectors typically vary significantly in their financial performance. The best way to judge whether a particular firm’s EBITDA is ‘good’ or ‘bad’ is to compare it with its competitors of more or less the same size in the same sector and industry.

What is meant by an firm’s EBITDA margin?

The following formula is used to calculate a company’s EBITDA margin:

EBITDA expressed as a percentage of total revenue, i.e. EBITDA / total revenue x 100.

By calculating what percentage EBITDA constitutes of a firm’s total revenue one can get a good indication of the percentage of cash profits that business generates during any given year. If one firm has a bigger EBITDA margin than another one, a professional investor is very likely to see more growth potential in the first one.

Let’s look at a practical example. Business A has a total annual revenue of $12 million and an EBITDA of $1.2 million, i.e. its EBITDA margin is 10%. Business B, on the other hand, has a higher total revenue of $20 million, and an EBITDA of $1.5 million.

We now have the interesting situation that company B has a higher EBITDA than company A ($750,000 versus $600,000) but the latter has a higher EBITDA margin (10% versus 7.5%). Everything else being the same, a prospective investor is, therefore, likely to see better long-term prospects for company A.

This means that, by calculating the EBITDA margin, an analyst, owner, or investor will be able to view the total amount of operating cash being generated as a percentage of all revenue earned. This is often used as a benchmark when choosing the most financially efficient business.

EBITDA limitations

EBITDA has over time acquired somewhat of a reputation because it is often being misused to hide or misrepresent certain facts. A spade, for example, is a good tool for digging a hole, it is not the best option if you want to inflate a tire or tighten a screw.

Similarly, it is not suitable as a standalone, one-size-fits-all tool for evaluating a firm’s profitability. This is especially relevant if one takes into account that EBITDA calculations do not comply with GAAP (Generally Accepted Accounting Principles) when it comes to calculating financial performance. This has made many analysts skeptical of using it, particularly since it presents the business as if it has never paid any taxes or interest and as if its assets are not steadily losing their value over time.

In this regard let us look at the example of a rapidly expanding manufacturing concern that year after year publishes increasing EBITDA data. To grow so fast, however, it bought a variety of fixed assets as the years went by, all funded with loans. Although it might appear that the firm has a robust growth potential, investors should not only study EBITDA but also metrics such as cash flow, capital expenditure, and net income.

Wrap up

To get a complete picture of the financial health of a particular business, a wide variety of different metrics should be analyzed. EBITDA is just one of them, albeit it a very useful one. After all, if identifying future winners in the business world was a simple as calculating one relatively simple indicator, everyone would be using it. Professional business analysts would stop existing. However, as we all know, this is not the case.