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What is 'EBITDA - Earnings Before Interest, Taxes, Depreciation and Amortization'

EBITDA stands for earnings before interest, taxes, depreciation and amortization. EBITDA is one indicator of a company's financial performance and is used as a proxy for the earning potential of a business, although doing so can have drawbacks. EBITDA strips out the cost of debt capital and its tax effects by adding back interest and taxes to earnings.

BREAKING DOWN 'EBITDA - Earnings Before Interest, Taxes, Depreciation and Amortization'

EBITDA is essentially net income with interest, taxes, depreciation and amortization added back to it. EBITDA can be used to analyze and compare profitability among companies and industries as it eliminates the effects of financing and accounting decisions. EBITDA is often used in valuation ratios and compared to enterprise value and revenue.

In its simplest form, EBITDA is calculated in the following manner:

                                EBITDA = Operating Profit + Depreciation Expense + Amortization Expense

The more literal formula for EBITDA is:

                                 EBITDA = Net Profit + Interest +Taxes + Depreciation + Amortization

If you're interested in learning how to calculate EBITDA using MS Excel we've got it covered.

Breaking Down EBITDA

Let’s take a look at the key factors that make up EBITDA. Interest is any income a business earns from its various investments. Taxes are, obviously, any of the obligations owed by the company to the Internal Revenue Service (IRS). Depreciation and amortization both reduce the costs of assets held by the business over time. 

By taking these out of the equation, EBITDA gives investors a good idea of how a company is doing financially and paints a portrait of how much cash a young or restructured company may generate before paying its debts. Using EBITDA as a metric also means it shows higher profits rather than simply providing operating profits. This is especially important for companies that are more focused on capital such as cable and telecoms. 

Example of EBITDA

A retail company generates $100 million in revenue and incurs $40 million in product cost and $20 million in operating expenses. Depreciation and amortization expense amounts to $10 million, yielding an operating profit of $30 million. The interest expense is $5 million, leading to earnings before taxes of $25 million. With a 20 percent tax rate, net income equals $20 million after $5 million in taxes are subtracted from pre-tax income. Using the EBITDA formula, we add operating profit to depreciation and amortization expense to get EBITDA of $40 million ($30 million + $10 million).

The Drawbacks of EBITDA

EBITDA is a non-GAAP measure that allows for a greater amount of discretion in what is and what is not included in the calculation. This also means that companies often change the items included in their EBITDA calculation from one reporting period to the next.

EBITDA came into more common use with leveraged buyouts in the 1980s, when it was used to indicate the ability of a company to service debt. As time passed, EBITDA became popular in industries with expensive assets that had to be written down over long periods of time. EBITDA is now commonly quoted by many companies, especially in the tech sector.

A common misconception is that EBITDA represents cash earnings. EBITDA is a good metric to evaluate profitability but not cash flow. EBITDA also leaves out the cash required to fund working capital and the replacement of old equipment, which can be significant. Consequently, EBITDA can be used as an accounting gimmick to dress up a company's earnings. When using this metric, it is key that investors also focus on other performance measures to make sure the company is not trying to hide something with EBITDA.

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