EBITDA

Earnings before interest, tax, depreciation and amortization

What is EBITDA?

EBITDA is a metric used to evaluate a company’s operating performance. It can be seen as a proxy for cash flow from the entire company’s operations. The acronym stands for earnings before interest, taxes, depreciation and amortization. It is a variation of the operating income because it excludes non-operating expenses and non-cash expenses. The purpose of these deductions is to remove the factors that business owners have discretion over such as debt financing, capital structure and methods of depreciation. The metric then focuses on the operating decisions of a business because it looks at the business’ profitability from its core operations before the efforts of capital structure and leverage are taken into account.

The following is the formula for EBITDA:

EBITDA = EBIT (Operating Income) + Depreciation + Amortization

Interest

Interest is excluded as it depends on the financing structure of a company. It comes from the money it has borrowed to fund its business activities. Different companies will have different capital structures, resulting in different interest expenses.

Taxes

Taxes vary, and it depends on the region where the business is in operating in. It is a function of tax rules, which is not really relevant in determining the business’ profitability.

D&A

Depreciation and amortization (D&A) depends on the historical investments the company has made and not on the current operating performance of the business.  It is heavily influenced by the assumptions regarding its useful economic life, its residual value and the depreciation methods used. Because of this, analysts may find the operating income somewhat dodgy and may have different view of what the number should be.

Why use it?

The metric is commonly used as a proxy to cash flow. It can give an analyst a quick estimate of the value of the company, as well as a valuation range by comparing a calculated EBITDA to the EBITDA multiple obtained from industry reports, industry transactions or M&A. In addition, when a company is not making a profit, potential investors can turn to EBITDA to evaluate a company. Many private equity firms use this metric because it is very good at comparing similar companies within the same industry.  Business owners use it to compare their performance against their competitors. It is especially useful for large companies with significant assets and not so much for small companies with no outstanding loans.

Disadvantages:

EBITDA is not recognized by GAAP. Some are skeptical (like Warren Buffett) of using it is because it presents the company like it has never paid any interests, any of its taxes, and it shows that assets have never lost their natural value over time (no depreciation or capex deducted).

For example, a fast-growing manufacturing company may present increasing sales and EBITDA year over year. To expand rapidly, it acquired many fixed assets over time and all were funded with debt. Although it may seem that the company has strong top-line growth, an investor would likely not want to invest in a company with significant, growing costs. Investors should look at other metrics in conjunction with EBITDA, like capital expenditures.