Written by Brenda Nakalema

What is EBITDA and why do you need to check it?

EBITDA is an acronym that stands for earnings before interest, taxes, depreciation and amortization. It assists analysts to make meaningful …

EBITDA is an acronym that stands for earnings before interest, taxes, depreciation and amortization. It assists analysts to make meaningful comparisons between companies, project long-term profitability of companies and gauge an entity’s ability to pay off future financing. The short-term operational efficiency of a company can be determined by EBITDA because the EBITDA margin ignores the effect of non-operating factors such as interest, taxes, depreciation and amortization, which makes this metric a more accurate measure of a company’s profitability.

The use of EBITDA in this way first became popular in the 1980s when leveraged buyouts were commonplace. At the time, investors used EBITDA as a yardstick to determine whether a failing business would be able to pay back the interest payments after it had been successfully restructured. Today, EBITDA is used by banks to assess a company’s debt service coverage ratio (DSCR), which is a debt-to-earnings ratio used to measure a company’s cash flow and ability to pay.

Like other profitability ratios, EBITDA can create a snapshot image of a company’s financial health at a given period of time. However, unlike other profitability ratios, EBITDA is mainly used by investors when comparing the performance of two or more companies in similar industries, with the view to determine which is more profitable than the other. By ignoring tax and interest expenses, investors are given the opportunity to focus specifically on the company’s operational performance. Depreciation and amortization are non-cash expenses that are excluded from the EBITDA calculation to provide a more realistic view of cash generation and the financing of capital investments. Income generation is measured relative to revenue to assess the actual operational efficiency of the company.

Interest expenses and interest income are added back to earnings which have the effect of neutralizing the cost of debt and the impact that those interest payments have on taxes. Income taxes are also added back to the net income, which may or may not increase the EBITDA- especially if the company has a net loss. Companies tend to rely heavily on their EBITDA when their performance has been lackluster. Companies also use depreciation and amortization accounts to expense the cost of property, plants and equipment or capital investments. Amortization is commonly used to expense the cost of software development or other intellectual property.

How is EBITDA used?

Companies that regularly acquire other companies use EBITDA to determine how a business portfolio might function when combined with the regular operations of a larger firm. Despite its advantages, Investors are sometimes wary of relying too heavily on EBITDA data because the metric loses explanatory value by omitting essential expenses. Generally Accepted Accounting Practices (GAAP) don’t apply EBITDA as a profitability measure.

Here is the formula for calculating EBITDA:

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

OR

EBITDA= Operating profit + Depreciation + Amortization

Components of EBITDA

Earnings

Earnings refer to what a company makes over a specified period of time. This is calculated by subtracting the operating expense from total revenue.

Interest

The interest expense arises as a result of money the company has borrowed from different entities to fund its activities- it is the cost of servicing debt. Because different companies have different capital structures that result in differing payments for interest, it is important to note; interest payments are tax-deductible- companies can take advantage of this in what is called a tax shield.

Taxes

Taxes vary from region to region and are therefore dependent on where the business is located and what tax laws are imposed in that region. Financial analysts prefer to add them back after calculating EBITDA since they don’t influence the analysis of a company’s management team.

Depreciation and Amortization

When companies invest in long-term fixed assets such as buildings, vehicles, certain types of machinery, the cost incurred by the business is deducted over a certain period of time owing to the wear and tear the assets undergo. The depreciation expense is based on a portion of the company’s fixed asset deteriorating over a certain period of time. Amortization is incurred as an expense if the asset is intangible. Depreciation and amortization are influenced by educated assumptions about the asset’s economic life, salvage value, and the depreciation method used. Because of these factors, analysts prefer to deduct the expense to create a certain uniformity in judging the performance of similar companies. The Depreciation and Amortization figure is recorded under the cash from operating activities section of the cash flow statement. Since depreciation and amortization are non-cash expenses, they are added back to the cash flow statement.

Sample cashflow statement

Cash from operating activities

Net earnings $50

Plus: Depreciation and Amortization $45

Less: Changes in working capital $0

Cash from Operations $95

Cash from investing activities

Investments in property and equipment $0

Investments in business $0

Cash from investing activities $0

Cash from financing activities

Issuance (repayment) of debt $0

Issuance (repayment) of equity $0

Payment of dividends $0

Cash from financing activities $0

Net increase (decrease) in cash $95

Opening cash balance $0

Closing cash balance $0

What is good EBITDA?

In analyzing two similar companies, the enterprise value/ EBITDA ratio can be applied to give investors a general overview of whether the company is overvalued (high ratio) or undervalued (low ratio). For EBITDA to be relevant, companies compared must be similar in nature (same industry, operations, customers, margins, growth rate etc. )

Because EBITDA is most commonly used to compare the performance of two similar companies, the first step is to calculate the margin by dividing EBITDA by Total revenue.

EBITDA margin= EBITDA / Total Revenue

Using this equation, the annual cash profit made by a business can be determined. The EBITDA margin can then be utilized to compare with another similar business in the same industry.

For example, Company X has an EBITDA of $900,000 while their total revenue is $ 9000,000. The EBITDA margin is 10%. Company Z has an EBITDA of $1,060,000 and a total revenue of $13,000,000.

This means that while company Z has a higher EBITDA ($1,060,000), investors would choose company X because it has a higher EBITDA margin (10%)

EBITDA vs. EBIT

EBIT (Earnings before Interest and Tax) is a company’s net income before the income tax expense, and the interest expense have been deducted. EBIT is used as a tool to analyze the performance of a company’s core operations without tax expenses and the cost of capital influencing the profit figure. The formula below is used to calculate EBIT:

EBIT= Net income + Interest expense + tax expense

Because of the fact that the calculation of net income involves subtraction of both the interest and tax expenses, they need to be added back to calculate the EBIT.

EBT (Earnings Before Tax) is a reflection of a company’s operating profit before taxes, while EBIT excludes both taxes and interest payments. EBT is calculated by adding taxes back to the net income figure to calculate a company’s profit.

Investors use EBT to evaluate a company’s operating performance after removing a variable cost that is largely outside their control.

Why use EBITDA?

EBITDA is commonly used in the place of cash flow- it gives an analyst a snapshot of a company’s value as well as allowing for comparison of companies in similar industries. Also, using EBITDA, an investor can apply a valuation multiple to determine the valuation range of a company. Another advantage of using this metric is that it allows an analyst to judge a company’s value and performance even if it hasn’t made any profits.

What is EBITDA margin?

By calculating the EBITDA margin, investors are not asserting that interest, taxes, depreciation and amortization are unimportant, the formula simply strips those components away in order to focus on the essentials: operating profitability and cash flow. Doing this makes it easier to compare the relative profitability of two or more companies of different sizes within the same industry. In calculating a company’s margin, investors are able to gauge how effective a company’s cost-cutting efforts have been.

Disadvantages of using EBITDA

EBITDA is not considered under Generally Accepted Accounting Principles (GAAP) as a performance measure. Because EBITDA doesn’t fall under GAAP, it’s a measure that varies from one company to another. It is common for companies to prefer highlighting EBITDA over net income because it is more flexible and can make it easy for other problem areas to be overlooked.

Investors should lookout for a potential warning sign when companies begin to over-emphasize their EBITDA performance- especially if it’s something they never did in the past. A company might choose to do when it’s heavily indebted or experiencing rising capital and developmental costs. This would render the EBITDA figure a possible distraction and might thus bias investors into viewing the company in a positive light.

While EBITDA is a great measure of a company’s performance over a period of time, some investors feel that the calculation of EBITDA ignores the actual cost of assets. A common misconception among certain investors is that EBITDA is a representation of cash earnings. In criticizing the use of EBITDA as a performance metric, investors assert that it assumes profitability is the sole result of sales and operations- ignoring the assets and financing question in how the company became profitable in the first place.

Another argument against the use of EBITDA states that EBITDA does not account for working capital fluctuations. Working capital represents a company’s liquidity at any given point in time, and just like amortization, taxes and capital expenditures, it changes from time to time. While a negative EBITDA is an indication of a company experiencing liquidity problems, a positive EBITDA is not necessarily indicative of a healthy company.

EBITDA provides an incomplete picture of how much money a company has available to cover its interest payments. Once depreciation and taxes are added back, the company finances can look a lot healthier than they actually are. EBITDA can also be manipulated by simply changing depreciation schedules to inflate a company’s profit projections.

Because interest and taxes are excluded from the EBITDA calculation, it presents the company being analyzed as if it has never incurred these expenses, which makes some investors sceptical of the results. Secondly, the exclusion of depreciation and amortization from the EBITDA calculation makes it seem as though the company’s assets have not incurred any wear over the years.

For instance, in the case of a manufacturing company that might have increasing sales and EBITDA figures year over year, analysts might assume it’s a great investment without taking into consideration the fact that the company used debt to finance its fixed assets like machinery.

EBITDA is also criticized for having varying starting points, therefore, making a comparison between companies difficult. While it might seem straightforward to simply subtract interest payments, taxes, depreciation and amortization from earnings, different companies use different earnings figures to initiate their EBITDA calculation. In other words, the calculation can be manipulated in the income statement according to the company’s whim. Even when distortions arising from interest, taxation, depreciation, and amortization arise, the figure generated is still unreliable.