Analysts use a number of metrics to determine the profitability or liquidity of a company. Earnings before interest, taxes, depreciation, and amortization (EBITDA) is often used as a synonym for cash flow, but in reality, they differ in important ways.
- Although in the past it has been a popular tool for calculating a company's market value and liquidity, EBITDA doesn't give an investor the full picture. By using cash flow analysis, an investor is able to consider items like loan interest, investment income, and taxes—something EBITDA doesn't allow for. Therefore, an EBITDA calculation should only be used to consider a wide-scope view of a company, but is not robust enough to be used to determine real financial health.
EBITDA became popular in the 1980s with the rise of the leveraged buyout industry. It was used to establish a company's operating profitability relative to companies with similar business models with no consideration given to their capital structure or in other words their use of debt or equity as their source of capital. EBITDA measures only the operating model of the company in a cash-focused fashion.
It does not care about Depreciation and Amortization as non-cash items, or the financing aspect of the business. However, EBITDA can measure a company's ability to service debt. Because this metric is not defined under the generally accepted accounting principles (GAAP), the calculation varies from company to company.
However, the basic formula is operating income, which is net revenue less operating expenses and cost of goods sold, with depreciation and amortization added back in. There is a second way to calculate it, and since they are similar, it comes down to individual preference. EBITDA aims to establish the amount of cash a company can generate before accounting for any additional assets or expenses not directly related to the primary business operations.
The Formula for Calculating EBITDA
Calculating EBITDA can be done in two different ways. The first is simple, and requires only simple addition. The first formula is:
EBITDA=Net Profit + Interest + Taxes + D + Awhere:D = DepreciationA = Amortization
As you can see, it is relatively easy. The second way to calculate EBITDA uses less steps, and is as follows:
EBITDA=Operating Income + DAwhere:DA = Depreciation and amortization
The second method is more popular if you have already received the accounting sheets, as the operating income will have already been calculated for you. Whichever method you decide to use, consider that EBITDA might not offer a complete enough financial picture for your needs.
In reality, however, a company's liquidity is very much affected by things such as loan interest, investment income, and taxes. Prudent cash flow management accounts for all funds coming in and going out of a business during a given period, so the calculation of cash flow is inherently different from that of EBITDA.
Many companies require a large amount of capital expenditure for heavy equipment or specialized facilities. The facilities and equipment depreciate over time and require upkeep and occasional replacement. These types of expenses are incorporated into the calculation of cash flow but not EBITDA. Because it neglects many kinds of expenses, a quick look at EBITDA can make a company look more liquid than it is. Cash flow is a much more comprehensive metric, and it provides a more reliable measure of a company's financial health.