What is EBITDA?
EBITDA is a metric used to assess a company’s operating performance. Earnings before interest, taxes, depreciation, and amortization, or EBITDA, sometimes acts as an alternative to other metrics, including net income or revenue. This metric does not account for a company’s capital investments or assets like property, equipment, plant, etc. It also excludes any expenditures related to debt by adding back taxes and interest expense to earnings.
To simply define, EBITDA is a measure of a company’s profitability that can be viewed as a proxy for other metrics like net income, revenue, or earnings.
EBITDA is used by many to ascertain business value because it looks at the financial implication of a company’s operating decisions. The calculation excludes the impact of non-operating decisions like major intangible assets, tax rates, and interest expenses. As a result, the company’s operating profitability reflects a more impressive number than the owners, investors, and buyers use to compare between companies.
However, this metric is not recognized by the US GAAP or IFRS as it does not include the depreciation of company assets.
This article will focus on the uses of EBITDA, how it is calculated, and the drawbacks of the metric.
- EBITDA abbreviation: Earnings Before Interest, Taxes, Depreciation, and Amortisation
- EBITDA is a widely used non-GAAP method to measure a company’s profitability
- This metric is often used to compare different company profiles and evaluate the industry averages
- A downside of EBITDA is that it does not account for a company’s cash flow that makes the company appear to have more money than it actually does
What Does EBITDA Stand For?
EBITDA full form is broken down below:
E – Earnings B – Before I – Interest T – Taxes D – Depreciation A – Amortisation
The EBITDA meaning and an in-depth explanation of the components are given below:
Earnings – Income Before – without considering the following factors in the metric: Interest – (or the expenses incurred by interest rates, like loans given by banks) as it banks on the financial arrangement of a company Taxes – (or the expenses incurred by tax rates enforced by the city, state, and the country) as it banks on the physical location of a company Depreciation – (or a non-cash expense indicating the steadily reducing value of a company’s assets) as it does not take the current performance into account, but the past investments Amortisation – (or a non-cash expense indicating the number of intangible assets over a time frame) because of the same reason as depreciation
How to Calculate EBITDA?
Now that you know the meaning of EBITDA, you need to understand how it is calculated.
The calculation of EBITDA is done by subtracting the expenses, excluding interest, taxes, depreciation, and amortization from a company’s net income.
The two formulas that are primarily used to calculate EBITDA are stated below:
EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortisation
EBITDA = Operating Income + Depreciation + Amortisation
Both EBITDA formulas are applied by companies to determine a particular portion of their business efficiently. The companies can freely add their choice of expense to the net income as GAAP does not acknowledge the metric. For example, a company can exclude taxes and depreciation if an investor intends to see its financial position if affected by debt.
To demonstrate an EBITDA example, we have taken the following Income Statement from Asian Paints as of 30 March 2019.
|Cost of revenue||11,49,88,200|
|Selling, general and administrative expenses||1,07,99,400|
|Income from operations||2,21,19,100|
According to the Cash Flow Statement, the company’s depreciation and amortisation were 43,06,700 INR.
Since EBITDA does not take interest and income taxes into account, the company’s EBITDA for Fiscal Year 2018-2019 will be:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortisation
= (21594900 + 510000 + 10988200 + 4306700) INR
= 37399800 INR
What is Good EBITDA?
This metric is a marker of a company’s profitability and overall financial performance. Naturally, a higher EBITDA is better than a lower one. The financial performance of companies varies between industries and areas. So, you can decide if a company has good EBITDA by comparing its figures with that of the competitors where the companies belong to the same area and industry and are of similar size.
You need to calculate the EBITDA margin to determine if the number is good or not.
What is the EBITDA Margin?
The EBITDA margin is a metric determining the relationship between a company’s total revenue and aggregate earnings. This margin is an indicator of the amount of cash profit a company can make in a year.
The margin is effective when comparing a company’s financial performance to its peers in a particular industry. That said, it is not recorded in the Financial Statement of the firm. So, analysts and investors need to calculate it independently. The formula used for the calculation is stated below:
EBITDA Margin = EBITDA / Aggregate Revenue
Potential acquirers are likely to consider a firm with a higher margin because it is deemed to have better growth potential.
EBITDA Coverage Ratio:
EBITDA Coverage Ratio is another way of determining how good your number is. Following is the formula for this metric:
EBITDA coverage ratio = (EBITDA + Lease Payments)/ (Interest Payments + Principal Payments + Lease Payments)
If the result is 1 or greater than 1, it implies that the company is in a good financially good position. It also indicates that the company can repay its liabilities.
Why Use EBITDA?
EBITDA is mostly used as an alternative to cash flow. Multiplying EBITDA by a valuation multiple taken from different sources like industry transactions and equity research reports can quickly assess a company’s value or a valuation range.
Investors can use this metric to evaluate a company when it is not making a profit. Similarly, several private equity companies use EBITDA as it is a great method for comparing enterprises within the same industry. This metric is also used by business owners to compare their business performance with the competition.
What are the Drawbacks of EBITDA?
EBITDA is quite beneficial for business owners, investors, and analysts as it offers a fair picture of a company’s value. But this widely used metric can be manipulated and can lead to adverse results for a business.
Some of the drawbacks of this metric are listed below:
- It does not show the worth of a company’s liquid assets or actual earnings. It also excludes debt expenses, which is why the final figure is deemed misleading.
- The metric is often used by business owners to cover their finance-related errors and flaws.
- Companies cannot use the only EBITDA as a metric to get an accurate reflection of their financial position.
- This metric does not consider depreciation and amortization as actual expenses while evaluating a company’s financial performance.
- EBITDA does not affect high-interest debts.
The Bottom Line:
We can conclude by saying that a company can report EBITDA as it wants. This is because, while the metric is used widely, it is not recognized by GAAP. As a result, the biggest drawback is that EBITDA does not reflect the company’s performance completely. Therefore, investors often avoid using this metric to understand the value of a business.
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