What is EBITDA
You might use the term ‘EBITDA’ in your day-to-day conversation, but are you acquainted with the nitty-gritty of its uses? What is its range of practical use? How can you use it with other metrics to give your financial reports a reality check? How can it help give you a quick summary of your financial performance?
EBITDA can give you a snapshot of your financial status, but if you make mistakes in either calculation or consideration of its components, it can lead to faulty projections. No executive wants to make that mistake. So, to help you, this article will discuss in detail the significance of EBITDA, its roles, limitations, and variations.
EBITDA stands for Earnings Before Interest, Tax, Depreciation, and Amortization. It’s a commonly used metric for measuring a business’s profitability. A good proxy for cash flow, EBITDA evaluates a company’s operating performance.
The key factor in this evaluation is that the company’s capital structure doesn’t impact the figures. It gives an idea of profitability, free of depreciation and amortization.
Here’s how it is calculated.
EBITDA Calculation
EBITDA = Net Income + Interest Expenses + Taxes + Depreciation & Amortization
Or
EBITDA = Operating Income + Depreciation & Amortization
Components of EBITDA
It’s important that you understand each of its components before knowing how to use it to make your life easier.
Net Income
Net income is the company’s revenue minus COGS (Cost of Goods Sold) and other expenses, including overhead costs, interest, tax, depreciation, and amortization. Operating Income is revenue minus operating expenses, which include COGS and overhead costs.
Interest Expenses
Any interests accrued to the company via debts, overdue payments, etc., come under the head of Interest Expenses.
Taxes
This component includes taxes paid to the local or national government. Again, taxes can vary between companies and regions. So, to make a correct comparison, you should remove taxes from the profit calculation.
Depreciation
Any company assets or long-term investments (like property, vehicles, etc.) undergo devaluation because of wear and tear. It affects the company’s profit figures and financial statements.
Amortization
Amortization is the process of gradually writing off the initial cost of an intangible asset over a period. In EBITDA calculation, it is the depreciation of intangible assets like patents and goodwill. These assets are amortized because they have a time-limited value.
An Example
Let’s consider an example. A company has a $100 million gross income and incurs $50 million in expenses, including the cost of goods sold and overhead expenses. Out of its $50 million operating expenses, depreciation and amortization costs total $10 million. It pays $10 million in interest and $10 million in taxes.
Net Income = $100 million (Gross Income) – $50 million (Expenses) – $10 million (D&A) – $ 10 million (Interests) – $10 million (Taxes) = $20 million
EBITDA = $20 million (Net Income) + $10 million (Interests) + $10 million (Taxes) + $10 million (D&A) = $50 million
Where D&A is Depreciation and Amortization.
Why Use EBITDA?
EBITDA is a widely used measurement tool for comparing profitability and operational efficiency across companies. You can also use it for business valuation, lending decisions, financial modeling, and cash flow analysis.
In short, EBITDA is a quick method to know your financials so you don’t run out of cash. It can help you review and compare your strategic initiatives, make fast decisions, and check if your external accountant is giving you the right reports.
However, to achieve all these things, you need to know its strengths and weaknesses. Let’s start with its limitations and criticisms.
Limitations and Criticisms
Some of its limitations are:
- EBITDA is not a standardized metric under US GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards). Because of this, companies can choose to include it or not in their income statements. Also, different companies can use various methods for calculating EBITDA, making it a nonstandard calculation.
- Being a non-standard process, there is a high chance of misinterpretation or overvaluation of profitability by EBITDA.
- It does not account for capital expenses and changes in working capital. But capital expenses are still expenses. While excluding them helps in comparing profitability, it gives a wrong idea about a single business’s efficiency in generating cash.
According to Warren Buffet, “References to EBITDA make us shudder … not a meaningful measure of performance.” Buffet emphasizes that depreciation is a real cost and can’t be ignored.
He also says, “Does management think the tooth fairy pays for capital expenditures.”
Excluding capital expenditures and depreciation may obscure the company’s value and make this calculation faulty. You need an expert financial analyst to analyze your financial data and identify potential risks. If you are not confident in crunching numbers and creating reports, tools like Bunker can give you automated analysis of your financials in a single platform.
Hence, it becomes important that we complement EBITDA with other financial metrics for a comprehensive analysis. Some variations and comparisons against other methods are:
EBITDA Margin
One method to overcome its limitations is by calculating EBITDA as a percentage of Total Revenue. You can calculate it as:
EBITDA Margin = EBITDA/Total revenue*100%
It gives a prudent comparison between companies informing about their profitability against generated revenue. Let’s take an example
Company A has an EBITDA of $40 million with revenue of $200 million. Meanwhile, Company B has an EBITDA of $20 million against an income of $80 million. The EBITDA margin can be calculated as:
| Company A | Company B | |
| EBITDA | $40 million | $20 million |
| Revenue | $ 200 million | $80 million |
| EBITDA Margin | 40/200*100% = 20% | 20/80*100 = 25% |
You can see that company B has a higher EBITDA Margin even with a lower EBITDA. This tells you that company B has a higher profit margin and thus carries a lower financial risk.
Although it varies from industry to industry, a general idea is that a 10% or more EBITDA margin is a good value. Note that different industries have different profit margins, expenses, and revenue structures.
Adjusted EBITDA
You may often have expenses and revenues that temporarily increase or decrease your EBITDA, giving a faulty figure. In such a case, your financial controller will calculate an adjusted EBITDA.
Adjusted EBITDA = EBITDA +/- A (Adjustments)
You can add back one-time and non-routine expenses like foreign exchange losses or excessive owner’s compensation; and deduct expenses that may be present in peer companies but not in your company.
Common adjustments include:
- Unrealized gains or losses
- Non-cash expenses (depreciation and amortization)
- Litigation expenses
- Higher than the market average owner’s compensation
- Gains or losses on foreign exchange
- Goodwill impairments
- Non-operating income
- Share-based compensation
These adjustments compensate for sudden temporary changes in cash flow, giving a clearer picture of ongoing operational performance. When comparing companies, adjusted EBITDA serves a better purpose than unadjusted EBITDA. So, it is wise to use it for valuation or lending purposes.
Operating Cash Flow
While EBITDA is important as a cash flow proxy and as an initial analysis of a company’s operational performance, if you depend on it completely, you might be misled. For example, EBITDA does not tell you about how much cash your company is generating. Thus, you cannot know about the problems in the receivables collection.
Because of this, Operating Cash Flow is a better indicator as it adds non-cash charges (depreciation and amortization) back to net income while including changes in working capital.
If you consider all of these points and combine EBITDA with other metrics, it can add value to your financial planning and analysis.
EBITDA in Business Valuation
EBITDA is a useful tool for the initial analysis of a company’s cash flow. Used effectively with adjustments and operating cash flow, it can help you in your business’s valuation and, thus, in mergers, acquisitions, and investment decisions. An important metric in company valuation is EV/EBITDA.
EV/EBITDA
While comparing, the ratio of Enterprise Value and EBITDA can give you an idea if the company is overvalued or undervalued. For example:
| Company A | Company B | |
| Enterprise Value | $100 million | $200 million |
| EBITDA | $10 million | $40 million |
| EV/EBITDA | 100/10 = 10 | 200/40 = 5 |
Here, Company B is undervalued because it has a lower ratio.
EBITDA Coverage Ratio
EBITDA can also help evaluators judge a company’s ability to service debt and thus help lenders make a decision. Its formula is:
EBITDA Coverage Ratio = (EBITDA + Lease Payments)/(Interest Payments + Principal Payments + Lease Payments)
If the ratio is 1 or greater than 1, this metric indicates that a business can repay its liabilities and is in a sound position.
Conclusion and Resources
EBITDA is a valuable metric for evaluating a company’s value, profitability, and competitive position. Combined with other metrics like Adjusted EBITDA, Operating Cash Flow, and EBITDA Coverage Ratio, it can help measure a business’s financial performance accurately.
However, GAAP does not recognize it, and hence, companies can have different standards for using it. So, it is important to be observant while interpreting EBITDA. You should not completely depend on it and should practice using other metrics alongside it.
Financial Controllers can help you in understanding your financial performance.
However, for startups, tools like Bunker, a financial analytics platform, help you cut down 70% of your time on manual, repetitive tasks like sourcing and aggregating data for internal management reports. Instead, you spend time understanding the data and making decisions.
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