EBITDA

Quick Summary of EBITDA

EBITDA is Earnings Before Interest, Taxes, Depreciation, and Amortization.

EBITDA or “earnings before interest taxes depreciation and amortization” is a commonly used measure of cash flow.

EBITDA can be calculated “top-down” by adding back DDA or depreciation and amortization deducted as sales costs to operating income before interest and taxes. EBITDA can also be calculated “bottom-up” by adding interest and DDA back to pretax income. For example, to find EBITDA, if the income statement shows $2 million of pretax income and DDA is $12 million and interest expense $6 million, then EBITDA is $20 million.

EBITDA became a standard tool for measuring cash flow leverage for LBOs in the 1980s. An EBITDA/debt ratio at a 2x multiple was considered the limit of safe leverage. EBITDA is often the cash flow measure most often associated with profitability comparison between investments. For example, enterprise value/EBITDA provides a valuation multiple of all of a company’s debt and equity times its cash flows.

EBITDA is not a GAAP-approved accounting measure because EBITDA neutralizes the effects of a company’s financing and accounting decisions.

EBITDA Calculation

The calculation for EBITDA is revenue(s) minus expenses, before tax, interest, depreciation, and amortization.

EBITDA gives the investor an idea of how much money the company has made before its deductions. It is especially useful for a new company that has just started business and has not yet been hit with taxes, payments to creditors, and so on.  EBITDA demonstrates to investors the ability to have a return on their investments.

EBITDA is a rough approximation for cash flow; it ignores many factors that have an impact on true cash flow, such as debt payments. Even so, it may be useful for evaluating firms in the same industry with widely different capital structures, tax rates, and depreciation policies.  EBITDA is often used in various evaluating ratios, such as EV/EBITDA and EBITDA margins.

Background

EBITDA first came to prominence in the 1980s during the period of a lot of leveraged buyouts. Investors wanted a quick metric to see if the company could handle the increased interest payment load in the short term that the restructuring would lead to. Since then, it has expanded and is used by many analysts and companies. Proponents say that it shows how a company is behaving on an operational level by stripping out expenses that might otherwise obscure things. However, depreciation and amortization are real expenses, being the “expensing” of assets purchased via capital expenditures over the lifetime of those assets. D&A, to abbreviate them, are legitimate expenses.

It is also useful for comparing companies of different capital structures (though EBIT would work as well for just that), tax rates, and depreciation policies. Investors and analysts, however, can usually adjust for such differences, at least the latter two.

One thing that keeps it popular, though, is that it shows a larger number than net income or operating profit would, thus making the company appear to be more profitable than it may truly be.

Further Dangers

Using EBITDA can overstate the company’s interest coverage ability. For instance, if it has $12 million in operating profit, but $14 million in interest payments, things look a lot better if you can add back in $8 million in D&A expenses so that it shows $20 million to cover the $14 million in interest.

Using EBITDA also is not a substitute for cash flow, as it ignores changes in working capital. By ignoring important business expenses, it can overstate the apparent cash flow.

Finally, it can make the company look cheaper than it really is. If one uses a price multiple to EBITDA. A 7 multiple sounds a lot better than a 20 multiple does.

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