EBITDA vs. Operating Income: An Overview
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) and operating income are two key measures of a company's profitability but they convey different information to the investor studying a company's balance sheet.
- EBITDA, as its name implies, strips out some of the costs of doing business in order to more clearly reveal its profitability from its core operations.
- Operating income adds some of those costs back in to reveal the company's actual net profit.
- Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) removes some of the costs of doing business in order to reveal the profitability of its core operations.
- Operating income shows how much money a business is making after its costs of doing business are deducted.
- Depending on the company and the industry, these figures can be radically different.
The term EBITDA is attributed to John Malone, the billionaire builder of a cable television empire. He wanted a more accurate measure of the performance of a company that had a rapidly increasing cash flow but was spending most of it on further expansion. EBITDA, he argued, more accurately reflected the success of a company that was going for economies of scale, such as those in the cable television business.
In that sense, EBITDA is a measure of the earnings potential of a business.
Not all agree on the usefulness of EBITDA. EBITDA can obscure a debt burden that significantly hampers a company's profitability. And, it ignores capital investments, which can be burdensome, especially in fast-growing companies.
EBITDA is calculated with the following formula:
EBITDA=I+Depreciation and Amortizationwhere:I=Operating Income
Operating income adds back some, but not all, of the numbers that are excluded from EBITDA.
It is a measure of a company's profitability after accounting for operating expenses including wages, depreciation, and the cost of goods sold. It does not include the cost of taxes and one-off items that can skew the company's profit numbers.
This number is often referred to as operating profit or recurring profit. Investors value it because it gives them a sense of how well the company is managing its costs.
An operating profit that increases year over year, or quarter to quarter, shows a company that is poised to continue making or even increasing a profit.
EBITDA vs. Operating Income Example
The difference between EBITDA and operating income may be best understood by studying a real income statement, such as this one from JC Penney Company Inc. (JCP), released May 5, 2018:
- 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 (highlighted in red). 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 counted in net income.
JC Penney's EBITDA of $144 million was radically different from its operating income of $3 million for the same period.
When comparing EBITDA and operating expenses, one metric is not necessarily better than the other. They show the profit of the company in different ways, by stripping out or adding back some costs.
Operating income includes the company's overhead and operating expenses as well as depreciation and amortization. However, operating income does not include interest on debt and tax expenses.
To calculate EBITDA, non-cash items like depreciation, taxes, and capital structure are stripped from the equation.
While EBITDA helps the investor see past possible management manipulation by removing debt financing, operating income can help analyze the production efficiency of a retailer's core operations and expense management.