EBITDA, or earnings before interest, taxes, depreciation, and amortization, is a measure of a company’s overall financial performance and is used as an alternative to net income in some circumstances. EBITDA, however, can be misleading because it does not reflect the cost of capital investments like property, plants, and equipment.
This metric also excludes expenses associated with debt by adding back interest expense and taxes to earnings. Nonetheless, it is a more precise measure of corporate performance since it is able to show earnings before the influence of accounting and financial deductions.
Simply put, EBITDA is a measure of profitability. While there is no legal requirement for companies to disclose their EBITDA, according to U.S. generally accepted accounting principles (GAAP), it can be worked out and reported using the information found in a company’s financial statements.
The earnings, tax, and interest figures are found on the income statement, while the depreciation and amortization figures are normally found in the notes to operating profit or on the cash flow statement. The usual shortcut to calculating EBITDA is to start with operating profit, also called earnings before interest and tax (EBIT), then add back depreciation and amortization.
EBITDA is calculated in a straightforward manner, with information that is easily found on a company’s income statement and balance sheet. There are two formulas used to calculate EBITDA, one that uses operating income and the other net income. The two EBITDA calculations are:
EBITDA = Net Income + Taxes + Interest Expense + Depreciation & Amortisation
EBITDA = Operating Income + Depreciation & Amortisation
It’s is essentially net income (or earnings) with interest, taxes, depreciation, and amortisation added back. EBITDA can be used to analyze and compare profitability among companies and industries, as it eliminates the effects of financing and capital expenditures. It’s is often used in valuation ratios and can be compared to enterprise value and revenue.
Interest expenses and (to a lesser extent) interest income are added back to net income, which neutralizes the cost of debt and the effect that interest payments have on taxes. Income taxes are also added back to net income, which does not always increase EBITDA if the company has a net loss. Companies tend to spotlight their EBITDA performance when they do not have very impressive (or even positive) net income. It’s not always a telltale sign of malicious market trickery, but it can sometimes be used to distract investors from the lack of real profitability.
Companies use depreciation and amortization accounts to expense the cost of property, plants, and equipment, or capital investments. Amortization is often used to expense the cost of software development or other intellectual property. This is one of the reasons why early-stage technology and research companies feature EBITDA when communicating with investors and analysts.
Management teams will argue that using EBITDA gives a better picture of profit growth trends when the expense accounts associated with capital are excluded. While there is nothing necessarily misleading about using EBITDA as a growth metric, it can sometimes overshadow a company’s actual financial performance and risks.
Matt Levine of Bloomberg defines LBOs quite neatly: “You borrow a lot of money to buy a company, and then you try to operate the company in a way that makes enough money to pay back the debt and make you rich. Sometimes this works and everyone is happy. Sometimes it doesn’t work and at least some people are sad.”
Leveraged buyout bankers promoted EBITDA as a tool to determine whether a company could service its debt in the short term. These bankers claimed that looking at the company’s EBITDA-to-interest coverage ratio would give investors a sense of whether a company could meet the heavier interest payments that it would face after restructuring.
EBITDA does not fall under the above-mentioned GAAP as a measure of financial performance. Because EBITDA is a “non-GAAP” measure, its calculation can vary from one company to the next. It is not uncommon for companies to emphasize EBITDA over net income because it is more flexible and can distract from other problem areas in the financial statements.
An important red flag for investors to watch is when a company starts to report EBITDA prominently but hasn’t done so in the past. This can happen when companies have borrowed heavily or are experiencing rising capital and development costs. In this circumstance, EBITDA can serve as a distraction for investors and may be misleading.
A common misconception is that EBITDA represents cash earnings. However, unlike free cash flow, EBITDA ignores the cost of assets. One of the most common criticisms of EBITDA is that it assumes profitability is a function of sales and operations alone—almost as if the assets and financing the company needs to survive were a gift.
EBITDA also leaves out the cash required to fund working capital and the replacement of old equipment. For example, a company may be able to sell a product for a profit, but what did it use to acquire the inventory needed to fill its sales channels? In the case of a software company, EBITDA does not recognize the expense of developing the current software versions or upcoming products.
While subtracting interest payments, tax charges, depreciation, and amortization from earnings may seem simple enough, different companies use different earnings figures as the starting point for EBITDA. In other words, EBITDA is susceptible to the earnings accounting games found on the income statement. Even if we account for the distortions that result from interest, taxation, depreciation, and amortization, the earnings figure in EBITDA is still unreliable.
Worst of all, EBITDA can make a company look less expensive than it really is. When analysts look at stock price multiples of EBITDA rather than at bottom-line earnings, they produce lower multiples.
Consider the historical example of wireless telecom operator Sprint Nextel. On April 1, 2006, the stock was trading at 7.3 times its forecast EBITDA. That might sound like a low multiple, but it doesn’t mean the company is a bargain. As a multiple of forecast operating profits, Sprint Nextel traded at a much-higher 20 times. The company traded at 48 times its net income.
Investors need to consider other price multiples than EBITDA when assessing a company’s value.
The above-mentioned EBIT is a company’s net income before income tax expense and interest expense have been deducted. EBIT is used to analyze the performance of a company’s core operations without tax expenses and the costs of the capital structure influencing profit.
The following formula is used to calculate EBIT:
EBIT=Net Income+Interest Expense+Tax Expense
Since net income includes the deductions of interest expense and tax expense, they need to be added back into net income to calculate EBIT. EBIT is often referred to as operating income since they both exclude taxes and interest expenses in their calculations.
However, there are times when operating income can differ from EBIT.
Earnings before tax (EBT) reflects how much of an operating profit has been realized before accounting for taxes, while EBIT excludes both taxes and interest payments.
EBT is calculated by taking net income and adding taxes back in to calculate a company’s profit.
By removing tax liabilities, investors can use EBT to evaluate a firm’s operating performance. In the United States, this is most useful for comparing companies that might have different state taxes or federal taxes. EBT and EBIT are similar to each other and are both variations of EBITDA.
Since depreciation is not captured in EBITDA, it can lead to profit distortions for companies with a sizable amount of fixed assets and subsequently substantial depreciation expenses. The larger the depreciation expense, the more it will boost EBITDA.
EBITDA is a measure of a company’s financial performance and profitability, so relatively high EBITDA is clearly better than lower EBITDA. Companies of different sizes in different sectors and industries vary widely in their financial performance. Therefore, the best way to determine whether a company’s EBITDA is good is to compare its number with that of its peers—companies of similar size in the same industry and sector.
EBITDA is a measure of profit, but net profits would also remove interest, taxes, and depreciation/amortisation. Therefore, it is a better proxy of gross profit than net profit.
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