EBITDA (earnings before interest, taxes, depreciation, and amortization) measures a company's profitability and is typically used to determine the earnings potential of a company.
EBITDA removes the costs of debt financing as well as depreciation, and amortization expenses from profits. Also, EBITDA shows a company's profit without taxes and interest expenses on debt. As a result, EBIDTA can be beneficial since it provides a stripped-down view of a company's profitability from its core operations.
Operating income is a company's profit after subtracting operating expenses. Operating expenses include selling, general and administrative expense (SG&A), depreciation, and amortization, and other operating expenses. Operating income is gross income minus operating expenses. Similar to EBITDA, operating income shows how much profit a company generates from its operations alone without interest expenses or tax expenses. However, EBITDA takes it one step further by striping out depreciation and amortization.
Comparing EBITDA and Operating Income
There are a couple of ways to calculate EBITDA, but one of the formulas is as follows:
EBITDA = Operating Income + Depreciation and Amortization
Since operating income is the net result of depreciation and amortization expenses being taken out, to calculate EBITDA, we need to add them back in. We can see the difference between EBITDA and operating income more clearly by looking at an example.
- Operating income was $3 million, highlighted in blue.
- Depreciation was $141 million, but the $3 million in operating income includes subtracting the $141 million in depreciation and amortization. As a result, depreciation and amortization are added back into operating income during the EBITDA calculation.
- EBITDA was $144 million for the period or $141 million + $3 million.
- We can see that interest expense and taxes are not included in operating income, but instead, are included in net income.
JC Penney's EBITDA of $144 million was quite different from their operating income of $3 million during the same period. One metric is not better than the other. Instead, they both show the profit of the company in different ways by stripping out and inputting different numbers.
Operating income includes overhead and operating expenses as well as depreciation and amortization. However, operating income does not include interest on debt and tax expense. Non-cash items like depreciation, as well as taxes, and the capital structure are stripped out when calculating EBITDA.
It's important for investors to use multiple profit metrics when analyzing the financial statements of a company. EBITDA helps to strip out management decisions or possible manipulation by removing debt financing, for example, while operating income can help analyze the production efficiency of a retailer's core operations and expense management.
But bear in mind that since depreciation and amortization are not in EBITDA, the profit of a company can get inflated. For example, if the company has sizable assets recorded as property, plant, and equipment, the depreciation expense would likely be quite large, and when added back in, it would boost EBITDA significantly.
EBITDA can also be calculated by taking net income and adding back interest, taxes, depreciation, and amortization. Please note that each EBITDA formula can result in different profit numbers. The difference between the two EBITDA calculations might be explained by the sale of a large piece of equipment or investment profits, but if that inclusion is not specified explicitly, this figure can be misleading. As a result, both EBITDA formulas might yield slightly different results depending on whether you start with operating income or net income. Investors should be aware of what goes into each calculation and the components that make up the difference.
For more on the different ways to calculate EBITDA including using net income, please read "What Is the Formula for Calculating EBITDA?"