EBITDA

What Is EBITDA?

EBITDA, or earnings before interest, taxes, depreciation, and amortization, is an alternate measure of profitability to net income. By stripping out the non-cash depreciation and amortization expense as well as taxes and debt costs dependent on the capital structure, EBITDA attempts to represent cash profit generated by the company’s operations.

EBITDA is not a metric recognized under generally accepted accounting principles (GAAP). Some public companies report EBITDA in their quarterly results along with adjusted EBITDA figures typically excluding additional costs, such as stock-based compensation.

Increased focus on EBITDA by companies and investors has prompted claims that it overstates profitability. The U.S. Securities and Exchange Commission (SEC) requires listed companies reporting EBITDA figures to show how they were derived from net income, and it bars them from reporting EBITDA on a per-share basis.

Understanding EBITDA

EBITDA is net income (earnings) with interest, taxes, depreciation, and amortization added back. EBITDA can be used to track and compare the underlying profitability of companies regardless of their depreciation assumptions or financing choices. Like earnings, EBITDA is often used in valuation ratios, notably in combination with enterprise value as EV/EBITDA, also known as the enterprise multiple.

What are the components of EBITDA?

To make proper use of EBITDA, you need to understand each component of the formula.

• Earnings:?Earnings are what your company brings in over a certain period. To determine this EBITDA component, subtract operating expenses from your total revenue.
• Interest:?An interest expense refers to the cost of servicing debt. It can also represent interest earned, though it generally refers to an expense. In EBITDA, the costs associated with interest are not deducted from earnings.
• Taxes:?Only two things are certain in life – death, and taxes – except when it comes to EBITDA, which measures a company’s earnings before taxes are paid. Earnings before interest and taxes are also commonly referred to as?operating profit, which can be expressed as EBIT.
• Depreciation and amortization:?Depreciation?represents the loss in value in tangible assets, such as machinery or vehicles, generally related to using over time. An amortization expense is related to the eventual expiration of?intangible assets, like patents. In EBITDA, depreciation and amortization are added back to operating profit.?

EBITDA is useful in the following business activities.

• Budgeting:?Say you’re planning your company’s budget for the next year and want to know if you can absorb the cost of upgraded machinery. With the EBITDA, you’ll have a good sense of your company’s financial health and will know if it’s the right time to add the extra expense.
• Downsizing:?If downsizing staff seems necessary, but you’re debating letting employees go or trying to weather the storm, an EBITDA analysis will help you make that decision objectively, not subjectively.
• Investing:?Say you have your eye on a company and are considering becoming an investor. The EBITDA can help you understand whether or not the company has strong growth potential, particularly when compared to other companies, so you can decide if joining the team is worthwhile.
• Forming an exit strategy:?If you’re ready to move on from your business and would like to put your company on the market, an EBITDA analysis can prove to buyers that it’s a smart purchase and help you set the correct asking price.?

EBITDA is especially widely used in the analysis of asset-intensive industries with a lot of property, plant, and equipment and correspondingly high non-cash depreciation costs. In those sectors, the costs that EBITDA excludes may obscure changes in the underlying profitability—for example, as for energy pipelines. Meanwhile, amortization is often used to expense the cost of software development or other intellectual property. That’s one reason why early-stage technology and research companies use EBITDA when discussing their performance.

Annual changes in tax liabilities and assets that must be reflected on the income statement may not relate to operational performance. Interest costs depend on debt levels, interest rates, and management preferences regarding debt vs. equity financing. Excluding all these items keeps the focus on the cash profits generated by the company’s business. Of course, not everyone agrees. “References to EBITDA make us shudder,” Berkshire Hathaway Inc. (BRK.A) CEO Warren Buffett has written. According to Buffett, depreciation is a real cost that can’t be ignored and EBITDA is not “a meaningful measure of performance.”

The reason why a company uses EBITDA is a crucial indicator of whether it’s using the formula in good faith. Startups, especially those that require heavy upfront investment to realize future growth, are likely to use EBITDA for good reasons. EBITDA is also effective for comparing a business against competitors, industry trends and macroeconomic trends. But if a struggling business suddenly starts relying on EBITDA when it never has before, the formula is likely not being used appropriately.?

No matter how you slice and dice your company’s financials, honesty in dealings with investors and potential buyers is essential to preserve your professional reputation. “The most important question for investors and analysts is to ensure that the company’s financials have been recently and thoroughly audited.

Misusing formulas like EBITDA to obscure shortcomings in your business is certain to ruin relationships and damage your brand. Always deal in good faith and use EBITDA and other financial metrics as intended, rather than as tools to make your business appear healthier than it truly is.