What is EBITDA?

Understanding EBITDA is important for business owners for two main reasons. First, it provides a clear picture of a company’s value. Secondly, it demonstrates a company’s worth to potential buyers and investors, showcasing its financial health and profitability.

The following guide to EBITDA for businesses looks at what this acronym means, what it shows, why it is useful and how it is calculated. We also identify what is classed as a good EBITDA margin, together with some of the different EBITDA ratios and what these demonstrate. Finally, we set out the main drawbacks and risks around EBTIDA, such as for investors, especially if using this as a sole financial measure of a company’s performance.

 

What is EBITDA?

 

EBITDA is an acronym for “Earnings Before Interest, Taxes, Depreciation and Amortization”, and represents a widely used measure of corporate profitability. It is essentially a metric used to evaluate a company’s operating performance, providing a key indicator of the core profit of a company and a shortcut way to snapshot its available cashflow.

Using EBITDA essentially removes the variables of certain capital structure costs by adding them back into the company’s net income or earnings. By removing these variables, the focus is shifted to the company’s ability to generate cash, regardless of how they choose to finance their business, how high their tax rate is or how quickly their assets lose value.

 

What does EBITDA show?

 

EBITDA (pronounced “ee-bit-dah”) is one of the most commonly used methods of assessing a company’s financial health and ability to generate cash, providing an alternative measure of profitability to net income. Each of the EBITDA terms can be explained as follows:

Earnings: also known as net profit or net income, ‘earnings’ are the total revenue generated from sales, minus the total amount deducted as legitimate business costs;

Before: the ‘before’ means that when the items below are added to the net income calculation, this should change the amount of profit in the company’s favour;

Interest: the term ‘interest’ includes business expenses caused by interest rates, such as interest charged on loans by banks or third-party lenders;

Taxes: the term ‘taxes’ comprises any income or other taxes imposed on the business. For example, for a UK company, this would include corporation tax imposed by HMRC, while for an American company, this would comprise any federal income taxes, as well as state or local taxes imposed in the region by the US government and regulatory authorities;

Depreciation: the term ‘depreciation’ indicates the reduction in the value of any tangible or physical assets over their useful life, such as machinery and equipment. This is a non-cash expense that signifies how much of an asset’s value has been used, ie; its asset value reduction, and is used to write off the cost of fixed company assets over a period of time.

Amortization: the term ‘amortization’ refers to the gradual discounting of the value of intangible assets, including goodwill and intellectual property, like patents, trademarks or copyright. As with depreciation, this is another non-cash expense and can be defined as a process that gradually writes off the initial cost to the company of non-physical assets.

 

Why is EBITDA useful?

 

Originally invented back in the 70s by John Malone, an American cable industry pioneer, as a metric to help sell lenders and investors on his leveraged growth strategy, EBITDA became popular during the 80s, at the height of the leveraged buyout era. It was common at that time for investors to financially restructure distressed companies, where EBITDA was useful in estimating whether a targeted company had the necessary profitability to service the debt likely to be incurred as a result of the acquisition. As such, it was used as a yardstick as to whether a business could afford to pay back the interest associated with restructuring.

Today, EBITDA remains a widely-used measure by banks and other lenders to assess whether a business is able to pay off its debts. It is also used by businesses to attract buyers and investors, often to help facilitate growth, demonstrating the performance and core profitability of a company, and acting as a loose proxy for the company’s overall cashflow.

As EBITDA does not account for different capital investment, debt and tax profiles, it can be used to compare two similar businesses and to understand a company’s overall ability to generate cashflow. EBITDA therefore allows lenders and investors to assess corporate profitability, net of those business expenses dependent on financing decisions, tax strategy and depreciation schedules. In particular, EBITDA can be used to compare the underlying profitability of companies regardless of any financing choices or depreciation assumptions. As such, EBITDA is widely used in the analysis of asset-intensive industries with lots of property, plant and equipment, with correspondingly high depreciation costs.

 

How is EBITDA calculated?

 

EBITDA can be calculated in one of two ways, where the first EBITDA formula is based on net income, by adding interest, tax, depreciation and amortisation expenses back on top of net profit, while the second is based on operating income, adding depreciation and amortisation expenses to operating profit. These two formulas can be expressed as follows:

EBITDA = net income + interest + taxes + depreciation & amortization expenses
EBITDA = operating income + depreciation & amortization.

However, to be able to calculate and use EBITDA effectively, it is important to understand how each component works together. Essentially, when using EBITDA, the interest that a company is charged when repaying its debt is added back to its earnings, together with any taxes, which are affected by all kinds of conditions that may not relate directly to the operating results for the business and can vary from one period to the next. Finally, EBITDA adds back both the loss in value over time from the use of tangible assets, plus the eventual expiring of intangible assets, referred to as depreciation and amortisation respectively.

 

What is a good EBITDA margin?

 

Calculating EBITDA is only the first step. The next step is to ascertain if the EBITDA calculated reflects a good and profitable position for a business. Companies can employ various different measures to evaluate their EBITDA calculation and derive meaningful information from this, including the EBITDA margin. This margin determines the percentage of calculated EBITDA against the overall revenue generated by the company, where the goal is to determine the amount of annual cash profit that a company makes.

If the EBITDA margin of any given company is greater than that of other companies, this typically indicates greater growth potential. The formula used to calculate this margin is EBITDA/total revenue. For example, if Company A has an EBITDA of $650,000, with a total revenue of $7,000,000, the resulting margin would be 9.3%. In contrast, if Company B has an EBITDA of $600,000, with a total revenue of $6,000,000, the resulting EBITDA margin would be 10%. Despite its higher EBITDA, Company A has a lower EBITDA margin as compared to Company B, indicating higher growth potential and a more promising future for Company B, where a margin of 10% or more is usually considered to be good.

Based on these results, potential buyers and investors weighing different options would find Company B to be a more lucrative option, even with the lower revenue and smaller EBITDA. As such, as a measure of corporate profitability, the higher the margin the better.

 

What are the different EBITDA ratios?

 

There are also various ratios that can be expressed when using EBITDA, including the debt-to-EBITDA ratio, the EBITDA-to-interest coverage ratio and the enterprise value-to-EBITDA ratio. These can all be used to provide different insights into a company’s health.

A debt-to-EBITDA ratio measures the amount of income generated and available to pay loans and other liabilities before interest, taxes, depreciation and amortization expenses. As such, a debt-to-EBITDA ratio helps to assess a company’s ability to pay off its debts, where a high ratio may indicate that the company’s debt is creating a heavy financial burden.

For example, if a company has £10 million debt and £1 million in EBITDA, the debt-to-EBITDA ratio is 10, where a ratio above 4 or 5 may often be seen as a red flag. This particular metric is commonly used by credit-rating agencies and lenders to assess the probability of defaulting, where some lenders might include a debt-to-EBITDA in their loan agreements, requiring businesses to keep to an agreed target or risk having to pay back the entire loan immediately. This ratio is also used by investors to gauge a company’s liquidity.

In contrast, EBITDA-to-interest coverage ratio is a financial ratio used to assess a company’s financial durability by examining whether it is at least profitable enough to pay off the interest on its outstanding debt, while the enterprise value-to-EBITDA ratio compares the value of a company, its debts included, to the company’s cash earnings less non-cash expenses. The EV/EBITDA metric tends to be a popular valuation tool with investors, helping to compare companies in order to make a sound investment decision.

 

What are the drawbacks of EBITDA?

 

As with any form of financial measure, there are drawbacks to using EBTIDA as a measure of corporate profitability — not least the use of different formulae and figures, the omission of capital costs and the risk that excluding capital expenditure, together with all the other cost exclusions, can obscure the true financial position, health and valuation of a company.

As EBITDA is a non-GAAP measure — where GAAP stands for Generally Accepted Accounting Principles — companies are free to interpret the formula used in reaching this figure. As such, the way in which EBITDA is calculated can vary from one company to the next, so the resulting EBITDA figure can often be misleading for those seeking to rely on it.

Further, even if account is taken of the distortions resulting from the exclusion of interest, taxation, depreciation and amortization costs, the earnings figure in EBITDA may still prove to be unreliable. This is because, as a starting point for EBITDA, different companies use different earnings figures. In other words, without a clear definition of earnings and a consistent approach here, EBITDA calculations may prove to be unreliable in other ways.

Another main drawback of EBITDA is the fact that it places focus on baseline profitability by eliminating capital expenditure. While some see this as the greatest strength of EBITDA, others perceive this as a potential drawback. This is because, by ignoring the costs of assets, EBITDA can allow problem areas to be glossed over. As a result, EBITDA may hide the risks associated with the company’s performance, where critics do not see EBITDA as a meaningful measure of performance without factoring in capital spending requirements.

It is also worth remembering that all the other cost exclusions in EBITDA can make a company look far less expensive than it really is. As such, EBITDA margins only really provide lenders and investors with a snapshot of short-term operational efficiency.

 

What are the risks of relying on EBITDA?

 

Admittedly, by excluding the impact of non-operating factors, such as interest expenses, taxes or intangible assets, the result can often provide a more accurate reflection of a company’s operating profitability than other metrics. Still, EBITDA margins should not be used to gloss over the fact that this measure excludes cash outlays for interest and taxes, as well as the eventual cost of replacing its assets. In other words, the drawbacks of using EBITDA as a sole financial measure of a company’s performance cannot be ignored, where those using EBITDA alone to assess a company’s value, or its results, risk getting it wrong.

Importantly, excluding some costs while including others in the use of EBITDA as a measure of profitability has also opened the door to the metric’s abuse by unscrupulous corporate managers. An important red flag for investors and lenders is when a company that has never reported EBITDA in the past suddenly starts to feature it prominently in its results. This can often happen when companies have borrowed heavily or are facing increasing capital and development costs. In these cases, EBITDA may be used to distract investors in an attempt to conceal the challenges that a company may actually be facing.

The bottom line is that EBITDA is a useful tool, but not one that should be used in isolation, either by business owners looking to finance or sell a company, or lenders and investors looking to fund or acquire a company. In the later scenario, it is always advisable to read the fine print reconciling the reported EBITDA to the net income of a company. Still, despite its downsides, EBITDA can be an especially helpful measure when comparing companies with different capital investment and debt profiles, or subject to disparate tax treatments.