What is EBITDA?
EBITDA, or earnings before interest, taxes, depreciation, and amortization, is an alternative measure of profitability compared to net income.
By excluding non-cash depreciation and amortization expenses, as well as taxes and debt costs related to the capital structure, EBITDA aims to represent the cash profit generated by the company’s operations
KEY TAKEAWAYS
- EBITDA is a widely used measure of core corporate profitability.
- EBITDA is calculated by adding interest, tax, depreciation, and amortization expenses to net income.
- EBITDA allows investors to assess corporate profitability net of expenses that depend on financing decisions, tax strategy, and discretionary depreciation schedules.
EBITDA Formulas and Calculation
There are two distinct EBITDA formulas, one based on net income and the other on operating income. The respective EBITDA formulas are:
EBITDA = Net Income + Taxes + Interest Expense + Depreciation & Amortization
and
EBITDA = Operating Income + Depreciation & Amortization
Understanding EBITDA
EBITDA can be used to track and compare the underlying profitability of companies, regardless of their depreciation assumptions or financing choices.
EBITDA is especially widely used in the analysis of asset-intensive industries with correspondingly high non-cash depreciation costs. In these sectors, the costs that EBITDA excludes may obscure changes in the underlying profitability.
History of EBITDA
EBITDA was invented in the 1970s to help sell lenders and investors on a leveraged growth strategy, which deployed debt and reinvested profits to minimize taxes.
It was used in leverage buyouts in the 1980s to estimate whether the targeted company would be profitable after the change in capital.
During the dotcom bubble, some companies used it to exaggerate their financial performance.
Drawbacks of EBITDA
EBITDA’s calculation can vary from one company to the next, as companies can emphasize EBITDA over net income to make themselves look better.
Not reporting EBITDA can be seen as a red flag. This can happen when companies have borrowed heavily or are experiencing rising capital and development costs.
Ignores Costs of Assets
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 company’s assets and debt financing were a gift.
What Defines Earnings?
While subtracting interest payments, tax charges, depreciation, and amortization from earnings, different companies use different earnings figures as the starting point for EBITDA.
EBITDA is susceptible to the earnings accounting games found on the income statement. Even if we account for these distortions, the earnings figure in EBITDA may still prove unreliable.
What Is a Good EBITDA?
EBITDA is a measure of a company’s profitability, so higher is generally better.
From an investor’s point of view, a “good” EBITDA is one that provides additional perspective on a company’s performance without making anyone forget that the metric excludes cash outlays for interest and taxes as well as the eventual cost of replacing its tangible assets.
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