What Is Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)?
EBITDA, or earnings before interest, taxes, depreciation and amortization, is a measure of a company's overall financial performance and is used as an alternative to simple earnings or net income in some circumstances. EBITDA, however, can be misleading because it strips out the cost of capital investments like property, plant, and equipment.
This metric also excludes expenses associated with debt by adding back interest expense and taxes to earnings. Nonetheless, it is a more precise measure of corporate performance since it is able to show earnings before the influence of accounting and financial deductions.
Simply put, EBITDA is a measure of profitability. While there is no legal requirement for companies to disclose their EBITDA, according to the U.S. generally accepted accounting principles (GAAP), it can be worked out and reported using information found in a company's financial statements.
The earnings, tax, and interest figures are found on the income statement, while the depreciation and amortization figures are normally found in the notes to operating profit or on the cash flow statement. The usual shortcut to calculate EBITDA is to start with operating profit, also called earnings before interest and tax (EBIT) and then add back depreciation and amortization.
The Formula for Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) Is
How to Calculate Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)
EBITDA is calculated in a straightforward manner, with information that is easily found on a company's income statement and balance sheet.
What Does EBITDA Tell You?
EBITDA first came to prominence in the mid-1980s as leveraged buyout investors examined distressed companies that needed financial restructuring. They used EBITDA to calculate quickly whether these companies could pay back the interest on these financed deals.
Leveraged buyout bankers promoted EBITDA as a tool to determine whether a company could service its debt in the near term, say over a year or two. Looking at the company's EBITDA-to-interest coverage ratio (in theory, at least) would give investors a sense of whether a company could meet the heavier interest payments it would face after restructuring. For instance, bankers might argue that a company with EBITDA of $5 million and interest charges of $2.5 million had interest coverage of two – more than enough to pay off debt.
The use of EBITDA has since spread to a wide range of businesses. Its proponents argue that EBITDA offers a clearer reflection of operations by stripping out expenses that can obscure how the company is really performing.
EBITDA is essentially net income (or earnings) with interest, taxes, depreciation and amortization added back. EBITDA can be used to analyze and compare profitability among companies and industries, as it eliminates the effects of financing and capital expenditures. EBITDA is often used in valuation ratios and can be compared to enterprise value and revenue.
Interest expenses and (to a lesser extent) interest income are added back to net income, which neutralizes the cost of debt as well as the effect interest payments have on taxes. Income taxes are also added back to net income, which does not always increase EBITDA if the company has a net loss. Companies tend to spotlight their EBITDA performance when they do not have very impressive (or even positive) net income. It's not always a telltale sign of malicious market trickery, but it can sometimes be used to distract investors from the lack of real profitability.
Companies use depreciation and amortization accounts to expense the cost of property, plants and equipment, or capital investments. Amortization is often used to expense the cost of software development or other intellectual property. This is one of the reasons that early-stage technology and research companies feature EBITDA when communicating to investors and analysts.
Management teams will argue that using EBITDA gives a better picture of profit growth trends when the expense accounts associated with capital are excluded. While there is nothing necessarily misleading about using EBITDA as a growth metric, it can sometimes overshadow a company's actual financial performance and risks.
- EBITDA is a widely used metric of corporate profitability
- EBITDA can be used to compare companies against each other and industry averages In addition, EBITDA is a good measure of core profit trends because it eliminates some of the extraneous factors and allows a more "apples-to-apples" comparison
- EBITDA can be used as a shortcut to estimate the cash flow available to pay debt on long-term assets, such as equipment and other items with a lifespan measured in decades rather than years
Example of How to Use EBITDA
A retail company generates $100 million in revenue and incurs $40 million in production cost and $20 million in operating expenses. Depreciation and amortization expenses total $10 million, yielding an operating profit of $30 million. Interest expense is $5 million, which equals earnings before taxes of $25 million. With a 20% tax rate, net income equals $20 million after $5 million in taxes are subtracted from pre-tax income. If depreciation, amortization, interest and taxes are added back to net income, EBITDA equals $40 million.
Many investors use EBITDA to make comparisons between companies with different capital structures or tax jurisdictions. Assuming that two companies are both profitable on an EBITDA basis, a comparison like this could help investors identify a company that is growing more quickly from a product sales perspective.
For example, imagine two companies with different capital structures but a similar business. Company A has a current EBITDA of $20,000,000 and Company B has EBITDA of $17,500,000. An analyst is evaluating both firms to determine which has the most attractive value.
From the information presented so far, it makes sense to assume that Company A should be trading at a higher total value than Company B. However, once the operational expenses of depreciation and amortization are added back in, along with interest expense and taxes, the relationship between the two companies is more clear.
In this example, both companies have the same net income largely because Company B has a smaller interest expense account. There are a few possible conclusions that can help the analyst dig a little deeper into the true value of these two companies:
- Is it possible that Company B could borrow more and increase both EBITDA and net income? If the company is underutilizing its ability to borrow, this could be a source of potential growth and value.
- If both companies have the same amount of debt, perhaps Company A has a lower credit rating and must pay a higher interest rate. This may indicate additional risk compared to Company B and a lower value.
- Based on the amount of depreciation and amortization, Company B is generating less EBITDA with more assets than Company A. This could indicate an inefficient management team and a problem for Company B's valuation.
EBITDA Versus EBT and EBIT
EBIT (earnings before interest and taxes) is a company's net income before income tax expense and interest expense have been deducted. EBIT is used to analyze the performance of a company's core operations without tax expenses and the costs of the capital structure influencing profit. The following formula is used to calculate EBIT:
- EBIT = net income + interest expense + tax expense
Since net income includes the deductions of interest expense and tax expense, they need to be added back into net income to calculate EBIT. EBIT is often referred to as operating income since they both exclude taxes and interest expenses in their calculations. However, there are times when operating income can differ from EBIT.
Earnings before tax (EBT) reflects how much operating profit has been realized before accounting for taxes, while EBIT excludes both taxes and interest payments. EBT is calculated by taking net income and adding taxes back in to calculate a company's profit.
By removing tax liabilities, investors can use EBT to evaluate a firm's operating performance after eliminating a variable outside of its control. In the United States, this is most useful for comparing companies that might have different state taxes or federal taxes. EBT and EBIT are similar to each other and are both variations of EBITDA.
Since depreciation is not captured in EBITDA, it can lead to profit distortions for companies with a sizable amount of fixed assets and subsequently substantial depreciation expenses. The larger the depreciation expense, the more it will boost EBITDA.
EBITDA Versus Operating Cash Flow
Operating cash flow is a better measure of how much cash a company is generating because it adds non-cash charges (depreciation and amortization) back to net income and includes the changes in working capital that also use or provide cash (such as changes in receivables, payables, and inventories).
These working capital factors are the key to determining how much cash a company is generating. If investors do not include changes in working capital in their analysis and rely solely on EBITDA, they will miss clues that indicate whether a company is losing money because it isn't making any sales.
The Drawbacks of EBITDA
EBITDA does not fall under generally accepted accounting principles (GAAP) as a measure of financial performance. Because EBITDA is a "non-GAAP" measure, its calculation can vary from one company to the next. It is not uncommon for companies to emphasize EBITDA over net income because it is more flexible and can distract from other problem areas in the financial statements.
An important red flag for investors to watch is when a company starts to report EBITDA prominently when it hasn't done so in the past. This can happen when companies have borrowed heavily or are experiencing rising capital and development costs. In this circumstance, EBITDA can serve as a distraction for investors and may be misleading.
EBITDA was a popular metric in the 1980s to measure a company's ability to service the debt used in a leveraged buyout (LBO). Using a limited measure of profits before a company has become fully leveraged in an LBO is appropriate. EBITDA was popularized further during the "dotcom" bubble, when companies had very expensive assets and debt loads that were obscuring what analysts and managers felt were legitimate growth numbers.
A common misconception is that EBITDA represents cash earnings. However, unlike free cash flow, EBITDA ignores the cost of assets. One of the most common criticisms of EBITDA is that it assumes that profitability is a function of sales and operations alone – almost as if the assets and financing the company needs to survive were a gift.
EBITDA also leaves out the cash required to fund working capital and the replacement of old equipment. For example, a company may be able to sell a product for a profit, but what did it use to acquire the inventory needed to fill its sales channels? In the case of a software company, EBITDA does not recognize the expense of developing the current software versions or upcoming products.
While subtracting interest payments, tax charges, depreciation and amortization from earnings may seem simple enough, different companies use different earnings figures as the starting point for EBITDA. In other words, EBITDA is susceptible to the earnings accounting games found on the income statement. Even if we account for the distortions that result from interest, taxation, depreciation and amortization, the earnings figure in EBITDA is still unreliable.
Worst of all, EBITDA can make a company look less expensive than it really is. When analysts look at stock price multiples of EBITDA rather than bottom-line earnings, they produce lower multiples.
Consider the historical example of wireless telecom operator Sprint Nextel. On April 1, 2006, the stock was trading at 7.3 times its forecast EBITDA. That might sound like a low multiple, but it doesn't mean the company is a bargain. As a multiple of forecast operating profits, Sprint Nextel traded at a much higher 20 times. The company traded at 48 times its estimated net income. Investors need to consider other price multiples besides EBITDA when assessing a company's value.
Limitations of EBITDA
Earnings before interest, taxes, depreciation and amortization (EBITDA) adds depreciation and amortization expenses back into a company's operating profit. Analysts usually rely on EBITDA to evaluate a company's ability to generate profits from sales alone and to make comparisons across similar companies with different capital structures. EBITDA is a non-GAAP measure and can sometimes be used intentionally to obscure the real profit performance of a company.
Because of these issues, EBITDA is featured more prominently by developmental-stage companies or those with heavy debt loads and expensive assets.
The measurement's sometimes bad reputation is mostly a result of overexposure and improper use. Just as a shovel is effective for digging holes, it wouldn't be the best tool for tightening screws or inflating tires. Thus, EBITDA shouldn't be used as a one-size-fits-all, stand-alone tool for evaluating corporate profitability. This is a particularly valid point when one considers that EBITDA calculations do not conform to generally accepted accounting principles (GAAP).
Like any other measure, EBITDA is only a single indicator. To develop a full picture of the health of any given firm, a multitude of measures must be taken into consideration. If identifying great companies was as simple a checking a single number, everybody would be checking that number, and professional analysts would cease to exist.