EBITDA Guide

Earnings before interest, tax, depreciation and amortization

What is EBITDA?

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization and 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 metric is a variation of the operating income (EBIT) because it excludes non-operating expenses and certain 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, methods of depreciation, and taxes (to some extent).

EBITDA then focuses on the operating decisions of a business because it looks at the business’ profitability from its core operations before the impact of capital structure, leverage and non-cash items like depreciation are taken into account.

 

ebitda

 

EBITDA is a non-GAAP metric in that it is not a recognized metric in use by IFRS or US GAAP. In fact, certain investors like Warren Buffet have a particular disdain for this metric, as it does not account for the depreciation of a company’s assets. For example, a company that has a large amount of depreciable equipment (and thus a high amount of depreciation expense) and EBITDA does not capture the expense of maintaining these capital assets.

 

EBITDA formula

Here is the formula for EBITDA:

EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization

 

Below is an explanation of each component of the EBITDA formula:

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.

Depreciation & Amortization

Depreciation and amortization (D&A) depend 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 a different view of what the number should be.

 

Why use EBITDA?

The metric is commonly used as a proxy for 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.

 

Disadvantages

EBITDA is not recognized by GAAP or IFRS. 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.

 

Relation to Valuation

Having said that, EBITDA metric is quite widely used in the finance industry. In fact, EBITDA is often used with enterprise value as a multiple for valuation. This is found by dividing a company’s enterprise value with EBITDA to find the EV/EBITDA multiple.

Additionally, while EBITDA is non-GAAP, it often appears in company financial statements. Some reporting standards like IFRS, however, require that the company disclose footnotes that reconcile EBITDA with the closest GAAP metric.

 

Use in financial modeling

EBITDA is used frequently in financial modeling as a starting point for calculating un-levered free cash flow.  Earnings before interest taxes depreciation and amortization is such a frequently referenced metric in finance that it’s helpful to use it as a reference point, even though a financial model only values the business based on its free cash flow.

To learn more, check out our video-based financial modeling courses.

 

More resources

We hope this has been a helpful guide to Earnings Before Interest Taxes Deprecation and Amortization.  If you’re looking for a career in corporate finance, this is a metric you’ll hear a lot about.  To keep learning more we highly recommend these additional resources: