An introduction to EBITDA
EBITDA stands for earnings before interest, taxes, depreciation, and amortisation.
It measures profitability from a company's core operations. EBITDA does this by excluding non-cash depreciation and amortisation expenses, as well as taxes and the costs of debt (which depend on the company's capital structure).
Essentially, it removes the factors that business owners have discretion over, such as its capital mix, financing, depreciation methods, and taxes (to an extent).
Investors consider EBITDA an essential tool when performing a fundamental analysis of a company's shares as it captures its financial performance before accounting for the impact of its capital structure. This makes it a handy metric to use when comparing the performance of companies with different debt levels or that operate in regions with varying tax rates.
Most companies report EBITDA in their financial statements as a key measure of their operating performance.
Key takeaways:
- EBITDA measures profitability, excluding the costs of financing and asset depreciation
- The metric allows the comparison of operational performances between companies and is used to determine debt servicing ability
- We can derive EBITDA from a company's financial statements.
Calculating EBITDA
There are two ways of calculating EBITDA:
EBITDA = Net income + interest expense + taxes + depreciation + amortisation
Or
EBITDA = Operating profit + depreciation + amortisation
Net income is revenue minus all the expenses and costs of generating that revenue, including selling, administrative, and operating expenses, depreciation, interest, taxes, and other costs.
Operating profit is the total earnings from the core business without deducting interest or taxes. Operating income does not include taxes or interest expenses, so adding these back to calculate the EBITDA is unnecessary.
The two formulas may give different EBITDA results depending on what items a company includes in its net income. For example, it may include one-off income or expense items in the net income but not the operating profit.
How to use the metric
EBITDA, by definition, separates earnings from the company's capital structure, making it helpful for comparing the performance of similar companies that finance assets differently.
It measures a company's operating performance and is commonly used as a proxy for cash flow. Multiplying EBITDA by the relevant multiple for its industry can provide an indicative valuation of a company. We can also use the metric to evaluate companies not generating a net profit.
By looking at EBITDA, investors can determine the underlying profitability of a company's operations, allowing for comparison to other businesses. Using those results, we can better understand the impact of capital structure and tax differences (particularly if companies operate in different countries) on actual profits and cash flows.
However, it's important to remember that using EBITDA in isolation can be deceptive. For example, if a company has high debt, then the net income, as opposed to EBITDA, would probably more accurately convey the company's risks and overall financial health. This is because net income considers financing costs, such as a company's interest payments.
Likewise, EBITDA does not capture the cost of maintaining and sustaining a company's assets and equipment because it doesn't include depreciation and amortisation expenses. This can be relevant when a company has a large amount of depreciable equipment.
At the end of the day, all expenses excluded from EBITDA (such as taxes) still have real-life financial implications that investors should pay attention to.
Variations of EBITDA
We can use several variations of EBITDA to help build a picture of the value of a company.
These include:
- EBIT = Earnings before interest and taxes
- EBIAT = Earnings before interest and after taxes
- EBID = Earnings before interest and depreciation
- EBIDA = Earnings before interest, depreciation, and amortisation
- EBITDAR = Earnings before interest, taxes, depreciation, amortisation, and rental costs
- EBITDARM = Earnings before interest, taxes, depreciation, amortisation, rental costs, and management fees.
However, these metrics cop some criticism in that they can be easily distorted and do not provide an accurate picture of cash flow. They also ignore the impact of actual expenses, such as fluctuations in working capital.
What is the EBITDA margin?
Analysts often use EBITDA to calculate a company's EBITDA margin. It's a valuable financial metric because it allows you to compare the relative profitability of companies of different sizes.
To calculate the EBITDA margin, divide EBITDA by total revenue. The higher the EBITDA margin, the lower the company's operating expenses relative to its revenue. A company with a high EBITDA margin is more efficient and likely to be more profitable overall because it generates high EBITDA while keeping operating expenses low.
How to compare companies using EBITDA
Let's evaluate the performance of two companies: Company A and Company B. Identical in every way, A is partially funded by debt while B is funded by equity.
Company A
- Total revenue = $5,000
- Cost of goods sold = $1,000
- Interest ($3,000 at 10% interest) = $300
- Depreciation = $500
- Income before taxes = $3,200
- Tax at 30% = $960
- Net income = $2,240
EBITDA = $2,240 + $500 + $300 + $960 = $4,000
Company B
- Total revenue = $5,000
- Cost of goods sold = $1,000
- Interest = $0
- Depreciation = $500
- Income before taxes = $3,500
- Tax at 30% = $1,050
- Net income = $2,450
EBITDA = $2,450 + $500 + $1,050 = $4,000
The comparison shows that both companies are the same from an operating performance perspective, with identical EBITDAs. However, Company B is more profitable in net income than Company A because it does not have debt servicing costs.
EBITDA vs operating cash flow
EBITDA falls short when it comes to reflecting the working capital requirements of a business. Operating cash flow is a better indicator because it accounts for cash coming in and out through payables and receivables and adds back non-cash expenses like amortisation and depreciation.
Operating cash flow has two other advantages over EBITDA. Firstly, it is included in a company's cash flow statement, so an investor or financial analyst requires no calculations.
Secondly, it is covered by the generally accepted accounting principles (GAAP), so there are prescribed ways that a company must present its operating cash flow. This means it is directly comparable across different companies.
What are the drawbacks?
GAAP does not cover EBITDA, so there is no universally prescribed way for companies to calculate EBITDA if they show it as a metric in their financial reports. Some companies may exclude specific one-off or non-recurring items on their income statements from their EBITDA calculations.
The fact that companies might have different approaches to calculating EBITDA does present a major drawback. It's difficult to compare figures between companies if they're calculated using different assumptions and methodologies.
Other drawbacks to consider when using this metric to evaluate a company's profitability include:
Ignoring the cost of assets: EBITDA overlooks the fact that financing costs and capital expenditure are significant elements driving company earnings. EBITDA can give the erroneous impression that only sales and operations are relevant to generating revenue.
Ignoring working capital: EBITDA fails to reflect the working capital needs of a business. Working capital is a measure of the financial health of a company. It is the difference between its current assets (like cash and inventory) and liabilities (like short-term debt). Positive working capital means the company has the liquidity to grow its business.
Because EBITDA doesn't consider financing costs, it can sometimes give an incomplete picture of a company's short-term financial health. For example, a company with high debt levels might show positive EBITDA. But, after paying interest, it might need more working capital to buy new inventory or finance its ongoing operations.
Varying starting points: The lack of GAAP requirements means companies can base their EBITDA calculations on different earnings figures. As we have shown, there are at least two ways to calculate EBITDA, and they can give different answers depending on the company in question.
Given the drawbacks discussed, it's clear that while EBITDA can provide a practical way to compare operating performances across companies and to evaluate debt servicing ability, analysts should not use it in isolation to assess profitability. However, EBITDA can still deliver valuable insights when used with other financial metrics, like a share's price-to-earnings (P/E) ratio.
Foolish takeaway
EBITDA offers a quick way to assess a company's operating performance and its ability to service debt. Investors can readily calculate it using items from a company's income statement.
However, you should use EBITDA alongside other performance measures if you want an in-depth understanding of a company's true financial health and overall financial performance.
Frequently Asked Questions
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EBITDA stands for earnings before interest, tax, depreciation and amortisation. It is one profitability measure investors and analysts can use to evaluate a company's financial performance. It captures the earnings the company has made from its core operations. Because EBITDA does not include interest, tax, depreciation, and amortisation expenses, it can be a helpful measure when comparing the underlying performance of different companies – particularly those operating in geographies with different tax rates. It is also agnostic about a company's leverage or how it accounts for capitalised expenses because it doesn't include interest, depreciation and amortisation.
However, be cautious when using EBITDA in your analysis. Many companies will quote an EBITDA figure on their financial statements, but there is no prescribed way for companies to calculate it because it is a non-GAAP measure. This means some companies might exclude one-off items to inflate their EBITDA. It's also worth pointing out that interest and tax expenses are still actual expenses and should not be entirely ignored. But, EBITDA can still be a valuable metric to use in combination with other types of company analysis.
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EBITDA should not be confused with gross profit. While we can use both metrics to assess a company's profitability, they are calculated in different ways and thus provide a different view of its core performance.
Gross profit is calculated as a company's total sales less the direct costs incurred from producing those goods or services (often referred to as 'costs of goods sold',or simply COGS). Like EBITDA, gross profit does not include interest, tax, depreciation and amortisation – but it also excludes other overheads not directly related to production, like advertising and marketing, rent and utilities, and accounting and other general and administrative expenses. EBITDA includes these other overheads. Therefore, as a general rule, EBITDA will always be lower than gross profit because it includes additional operating expenses that do not form part of the direct costs of production or COGS.
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As it is a profitability measure, the higher the EBITDA, the better. It means the gap between what the business earns from its sales and what it pays in operating expenses is extensive.
However, be mindful that EBITDA does not include interest expenses. The metric will not reveal if a company uses high amounts of debt to sustain its operations. So, a company's core earnings can appear very high based on its EBITDA and still be unprofitable. Some investors won't mind this. Growing companies often borrow heavily early in their lifecycle before expanding into profitable companies. In this case, showing that core earnings are strong can indicate the company's long-term potential.
Ultimately, EBITDA should be used to compare different shares to determine which suits your investing objectives best. This makes EBITDA a relative measure, rather than an absolute one. So, what is considered a 'good' EBITDA will vary between different industries and share types. And, as with all financial metrics, EBITDA should always be used in combination with other types of analysis when developing an investment thesis – never use it in isolation.
