The acronym EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Businesses will use EBITDA to gain a better understanding of how they are performing during a given period. It can also in certain circumstances help provide a picture of their cash flow position. Essentially, EBITDA shows operating income while deducting for expenses that are non-cash based. The expenses subtracted are such that owners tend to have greater control over to include debt and depreciation. In this article, we take a look at the EBITDA formula and why business owners need to calculate.
A business makes a series of decisions to improve operating performance. Assessing the results of these decisions can be more effectively done by looking at their EBITDA. How profitable the company is apart from the impact of non-cash items is what is evaluated in large part by looking at the EBITDA calculation.
For some experts, however, EBITDA is not a reliable metric as it fails to paint a comprehensive picture of true profitability concerning operating performance. However, many do find it useful when it comes to making operating adjustments where necessary.
The EBITDA Formula
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
It is important to understand all of the elements involved with the above EBITDA formula.
The interest arises from a company’s debt or the money that was borrowed to finance certain projects and/or activities of the business. It is easiest to strictly compare one company’s performance against another as far as EBITDA is concerned about factoring interest into the formula. Keep in mind too, that interest payments as a result of debt financing are tax-deductible.
Taxes paid will differ from company to company; this is because businesses are located in different states of course and from state to state what a company will pay in taxes varies. Because taxes are not part of assessing the efficacy of business operations, they are included in the EBITDA formula and can again, prove useful in comparing one company’s performance against another.
Depreciation & Amortization
Depreciation and amortization are related to the investments a company has made in the past. They, therefore, do not factor into the overall operating performance of a business. Let’s say a company invests in a long-term fixed asset such as real estate or some form of heavy equipment. Over time due to several factors, these assets will decrease in value. This is where depreciation expenses come into play. As far as amortization, this is what is applied if the asset in question is an intangible asset, so for instance, a patent would amortize given that it is considered an intangible asset.
Depreciation and amortization are both non-cash expenses and are therefore included in EBITDA; they can generally be found on a business’s cash flow statement under ‘cash from operating activities.’
Understanding Why We Use EBITDA
Barring other metrics, the EBITDA metric is one that will provide a snapshot of the overall value of a company at a specific time. So if an investor is considering putting money into a certain business and they are concerned with the company’s profitability, they can look at the EBITDA to see where that business stands. It is also helpful since EBITDA proves quite useful for comparing companies within a single industry. To this end, businesses can look at their EBITDA to see how they are performing in comparison to their competitors without factoring in debts and taxes.
Limitations of EBITDA
EBITDA is considered a non-GAAP measure (Generally Accepted Accounting Principles). Because of this, calculations can vary from company to company. Some businesses will prioritize the EBITDA metric over their net income because it does not account for certain factors that might otherwise paint a bleaker financial picture.
For example, if all of a sudden, a business starts to report EBITDA regularly whereas before they had refrained from doing so, this could be a potential red flag. The reason for this could be that a company is taking on a large amount of debt where before they were not. Reporting EBITDA can make the financial health of that particular business look better than it is.
Another drawback of EITDA as argued by many is that it does not account for the cost of assets. So what happens is that the profitability of a business seems solely dependent on sales versus any assets and/or finances that the business needed to keep moving forward. In other words, EBITDA assumes that there is a sort of “free cash flow” just given to the company in question.
EBITDA also does not factor in any money paid out to acquire working capital and equipment. If a company has to finance materials and inventory to put a product out on the market, EBITDA ignores this expenditure and rather shows the product as being profitable to the company based on the sales numbers alone.
The question of the EBITDA starting point is also mired in some confusion. Certainly, the formula which subtracts interest, taxes, depreciation, and amortization from earnings seems relatively simple, however, different companies will use different earnings numbers as their starting point in this formula. This makes it even more misleading in terms of trying to compare company performances against one another.
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