Understanding EBITDA

Continuing Learning Series

Monday, November 4, 2019

This article is a part of ACS Continuing Learning Series, which is a series of short articles, published by ACS Consulting at short regular intervals on a variety of subjects related to strategy, corporate finance, financial planning & analysis, business planning and performance management.

To view this article on ACS Consulting Blog, please follow the link:

https://www.acsconsulting.pk/post/ebitda

Subject: Financial Analysis

Relevance:

• Anyone who aspires to pursue a career as an investment analyst.
• Anyone who aspires to pursue a career within corporate finance.
• Anyone who is generally interested in accounting concepts investment appraisals.

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EBITDA Defined

Earnings before interest, taxes, depreciation & amortization (EBITDA) is a measure of a business’s profitability which is widely used by investors to assess real business performance and make comparison between firms in the same line of business. In some cases, it can also provide a more accurate view of the company's real performance over time. Another similar measure (EBITA) does not exclude depreciation from the accounting profit (explored further below).

Why EBITDA

Profitability is earnings generated throughout the ordinary course of doing business. A clearer picture of the company's profitability may be gained if capital expenditures and financing costs are subtracted from the official earnings total.

Accounting standards and conventions have arguably taken the concept of prudence to a level that the reported accounting profits could contain a lot of noise and distortion making performance evaluation and benchmarking performance rather difficult for investment analysts. The shareholder value has a very weak correlation with accounting profits whilst generation of cash is known to be strongly correlated with shareholder’s value creation. As a result, a number of measures have been developed to bring the reported accounting profits closer to cash flows for analysis purposes. An extreme such measure is Economic Value Added (EVA) which is known to be a strong indicator of shareholder value creation but is difficult to calculate and understand. Explanation of EVA is beyond the scope of this article. EBITDA or EBITA which are target subject of this article are simple to calculate and easy to understand measures.

EBITDA provides a more accurate view of a company's real performance over time by removing several factors that may distort the performance picture. The measure also allows easier comparison of one company to another in the same industry. Let us find out how?

Understanding EBITDA in Detail

Depreciation, in company accounting, is the recording of the reduced value of the company's assets over time. It's the wear and tear on the equipment and facilities. Some companies such as those in the utilities, manufacturing, and telecommunications industries, require significant expenditures in equipment and infrastructure, which are reflected in their books.

Amortization is a similar term which normally means recording of the reduced value of the company’s intangible assets over time.

To calculate a company's EBITDA, you must first determine the company’s earnings before tax (EBT). This figure appears in the company's income statements and other investor relations materials. Add to this figure any interest (financing costs) and depreciation & amortization costs. So, the formula is: EBITDA = EBT + interest expense + depreciation + amortization expense.

Let us attempt to understand it better with an example. Assume that in 2018, XYZ company had $1,000,000 of revenues and earned a net profit of $390,000 for the year. The business subsequently took out a loan of $500,000 to buy capital machinery which is expected to last for 5 years with no value at the end of those five years. The following year, sales rose to $1.2 million but net profit decreased to $380,000, down from the previous year.

At a first glance, it appears that the business has performed worse than the last year. However, on further investigation, you may find that the underlying performance of the business was actually better this year i.e. increased revenues and increased margins. Since the business borrowed money (and presumably had to pay interest on it which is an expense) and since the business now operated with a larger assets base resulting into additional depreciation expense, ($500,000/5 = $100,000) the reported accounting profit went down.

By removing these distortions which does not have anything to do with the operational effectiveness of the business, EBITA or EBITDA helps with uncovering the underlying business performance. This example demonstrates the importance of studying multiple metrics when evaluating the performance of a business.

EBITDA or EBITA

Both EBITA and EBITDA are useful tools in gauging a company's operating profitability. Analysts generally consider both EBITA and EBITDA to be reliable indicators of a company’s cash flow. EBITDA, however, can sometimes be misleading in certain circumstances because it strips out the cost of capital investments like property, plant, and equipment as explained below.

Some industries require significant investment in fixed assets. Using EBITA to evaluate companies in those industries may distort a company's profitability by ignoring the depreciation of those assets. EBITA of business operating in such industries is deemed to be a more appropriate measure of its operating profitability.

In other words, the EBITA measurement may be used instead of EBITDA for companies that have substantial capital expenditures which may skew the numbers.

EBITDA and Leveraged Buyouts

EBITDA first came to prominence in the mid-1980s as leveraged buyout investors examined distressed companies that needed financial restructuring. They used EBITDA to calculate quickly whether these companies could pay back the interest on these financed deals.

Leveraged buyout bankers promoted EBITDA as a tool to determine whether a company could service its debt in the near term, say over a year or two. Looking at the company's EBITDA-to-interest coverage ratio (in theory, at least) would give investors a sense of whether a company could meet the heavier interest payments it would face after restructuring. For instance, bankers might argue that a company with EBITDA of $5 million and interest charges of $2.5 million had interest coverage of two – more than enough to pay off debt.

EBITDA Drawbacks & Limitations

EBITDA does not fall under generally accepted accounting principles (GAAP) as a measure of financial performance. Because EBITDA is a "non-GAAP" measure, its calculation can vary from one company to the next. It is not uncommon for companies to emphasize EBITDA over net income because it is more flexible and can distract from other problem areas in the financial statements.

An important red flag for investors to watch is when a company starts to report EBITDA prominently when it hasn't done so in the past. This can happen when companies have borrowed heavily or are experiencing rising capital and development costs. In this circumstance, EBITDA can serve as a distraction for investors and may be misleading.

EBITDA ignores costs of assets

Whilst EBITDA brings reported earnings closer to cash flow, a common misconception is that EBITDA represents cash earnings. Unlike free cash flow, EBITDA ignores the cost of assets. One of the most common criticisms of EBITDA is that it assumes that profitability is a function of sales and operations alone i.e. investment & borrowing decisions does not impact long-term profitability which is a wrong assumption.

EBITDA Ignores Working Capital

Whilst free cash flow includes changes in working capital, EBITDA leaves out the cash required to fund working capital and the replacement of old equipment. For example, a company may be able to sell a product for a profit, but what resources did it use to acquire the inventory needed to fill its sales channels? In the case of a software company, EBITDA does not recognize the expense of developing the current software versions or upcoming products.

Varying Starting Points

While subtracting interest payments, tax charges, depreciation, and amortization from earnings may seem simple enough, different companies use different earnings figures as the starting point for EBITDA. In other words, EBITDA is susceptible to the earnings accounting games found on the income statement. Even if we account for the distortions that result from interest, taxation, depreciation, and amortization, the earnings figure in EBITDA could still be unreliable.

Obscures Company Valuation

Worst of all, EBITDA can make a company look less expensive than it really is. When analysts look at stock price multiples of EBITDA rather than bottom-line earnings, they produce lower multiples.

Other Limitations of EBITDA

Earnings before interest, taxes, depreciation, and amortization (EBITDA) adds depreciation and amortization expenses back into a company's operating profit. Analysts usually rely on EBITDA to evaluate a company's ability to generate profits from sales alone and to make comparisons across similar companies with different capital structures. EBITDA is a non-GAAP measure and can sometimes be used intentionally to obscure the real profit performance of a company.

Because of these issues, EBITDA is featured more prominently by developmental-stage companies or those with heavy debt loads and expensive assets.

Conclusion

EBITDA is a simple and easy to understand measure which could be very useful for business performance appraisal. Some of its bad reputation is probably a result of improper use and over exposure. EBITDA should not be used as a ‘one-size-fits-all’, stand-alone tool for evaluating corporate profitability. Like any other measure, EBITDA is only a single indicator. To develop a full picture of the health of any given business, a multitude of measures must be taken into consideration.

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