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EBITDA

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.

 

EBITDA calculation example

Image: CFI’s Financial Analysis Course.

 

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). It can be used to showcase a firm’s financial performance without accounting for its capital structure.

 

definition of EBITDA

 

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.

It 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) then the cost of maintaining and sustaining these capital assets is not captured.

 

EBITDA Formula

Here is the formula:

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

OR

EBITDA = Operating Profit + Depreciation + Amortization

 

Below is an explanation of each component of the 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. Note that interest payments are tax deductible, meaning corporations can take advantage of this benefit in what is called the corporate “tax shield”.

 

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. This is an expense of a business that must be paid to the government in the jurisdiction of the company.

 

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. Companies invest in fixed assets (such as buildings or vehicles) that lose value due to wear and tear. The depreciation expense is based on a portion of the company’s tangible fixed assets being deteriorated. Amortization expense is incurred if the asset is intangible. Intangible assets such as patents are amortized because they have a limited useful life (competitive protection) before expiration.

D&A is heavily influenced by the assumptions regarding useful economic life, residual value and the depreciation method used. Because of this, analysts may find that operating income is different than what they think the number should be, and therefore D&A is backed out.

This expense can be located in the firm’s Cash Flow Statement under the operating activities section. Since depreciation and amortization is a non-cash expense, it is added back (the expense is usually a positive number for this reason) while on the cash flow statement.

 

EBITDA Cash Flow Statement

Example: The depreciation and amortization expense for XYZ is $20.

 

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 multiplying it by a valuation multiple obtained from equity research reports, industry transactions or M&A.

In addition, when a company is not making a profit, 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 Capital Expenditures deducted).

For example, a fast-growing manufacturing company may present increasing sales and EBITDA year over year (YoY). 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 as well, such as capital expenditures, cash flow, and net income.

 

EBITDA Used in Valuation (EV/EBITDA Multiple)

When comparing two companies, the Enterprise Value/EBITDA  ratio can be used to give investors a general idea of whether a company is overvalued (high ratio) or undervalued (low ratio). It’s important to compare companies that are similar in nature (same industry, operations, customers, margins, growth rate etc.) as different industries will have vastly different ratios (high ratios for high-growth industries, low ratios for low-growth industries).

The metric is widely used in business valuation and is found by dividing a company’s enterprise value by EBITDA.

 

EBITDA multiple is a comps table

Image: CFI’s Business Valuation Course.

 

EV/EBITDA Example:

Company ABC and company XYZ are competing grocery stores that operate in the New York. ABC has an enterprise value of $200M and an EBITDA of $10M, while firm XYZ has an enterprise value of $300M and an EBITDA of $30M. Which company is undervalued on an EV/EBITDA basis?

Company ABC:                                                         Company XYZ:

EV = $200M                                                              EV = $300M

EBITDA = $10M                                                        EBITDA = $30M

EV/EBITDA = $200M/$10M = 20x                          EV/EBITDA = $300M/$30M = 10x

On an EV/EBITDA basis, company XYZ is undervalued because it has a lower ratio.

 

EBITDA 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.

 

EBITDA is calculated in financial modeling

 

Image: CFI’s video-based financial modeling courses.

 

Example Calculation #1

Company XYZ accounts for their $20 depreciation and amortization expense as a part of their operating expenses. Calculate their Earnings Before Interest Taxes Depreciation and Amortization:

 

EBITDA Income Statement 1

 

EBITDA = Net Income + Tax Expense + Interest Expense + Depreciation & Amortization Expense

= $25 + $20 + $10 + $20

= $75

EBITDA = Revenue – Cost of Goods Sold – Operating Expenses + Depreciation & Amortization Expense

= $100 – $20 – $25 + $20

= $75

 

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Example Calculation #2

Company XYZ’s depreciation and amortization expense are incurred from using their machine that packages the candy they sell. They pay 5% interest to debtholders and have a tax rate of 50%. What is XYZ’s Earnings Before Interest Taxes Depreciation and Amortization?

 

EBITDA Income Statement 2

First Step: Fill out income statement

Interest expense = 5% * $40 (operating profit) = $2

Earnings Before Taxes = $40 (operating profit) – $2 (interest expense) = $38

Tax Expense = $38 (earnings before taxes) * 50% = $19

Net Income = $38 (earnings before taxes) – $19 (tax expense) = $19

*Note: net income can also be found in the Cash Flow Statement, above the depreciation and amortization expense.

 

Second Step: Find the depreciation and amortization expense

In Cash Flow Statement, the expense is listed as $12.

Since the expense is attributed to their machines that package their candy (the depreciating asset directly helps with producing inventory), the expense will be a part of their cost of goods sold.

 

Third Step: Calculate Earning Before Interest Taxes Depreciation and Amorization

 

EBITDA = Net Income + Tax Expense + Interest Expense + Depreciation & Amortization Expense

= $19 + $19 + $2 + $12

= $52

 

EBITDA = Revenue – Cost of Goods Sold – Operating Expenses + Depreciation & Amortization Expense

= $82 – $23 – $19 + $12

= $52

 

More resources

We hope this has been a helpful guide to Earnings Before Interest Taxes Depreciation and Amortization.  If you are 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:

  • EBIT vs EBITDA
  • Valuation methods
  • Financial modeling guide
  • How to be a great financial analyst

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