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In a business, it's the numbers that tell the story. Is the business operating at a profit? Is it being impacted by the effects of financing and accounting decisions? Companies can report their financial conditions with several metrics, including sales, operating profits and net income. One nonstandard and slightly controversial measure of financial performance is earnings before interest, taxes, depreciation and amortization, or EBITDA. We'll get into the pros and cons of EBITDA, but first let's get a better handle of what it means.
EBITDA is a measure of a company's financial performance. Here are the terms that make up EBITDA.
|Earnings||Refers to either net profit or operating profit.|
|Net profit||The profit you earn after accounting for all income, gains, expenses and losses.|
|Operating profit||The profit you earn from operations. Does not include income/expenses or gains/losses from nonoperating sources, such as the sale of property or the cost of a court judgement. Includes amortization and depreciation expenses.|
|Interest||The interest you pay on debt.|
|Taxes||Income taxes you incur during the period.|
|Depreciation||A multiyear, noncash expense to recover the cost of a tangible fixed asset, such as a building, vehicle or equipment.|
|Amortization||A multiyear, noncash expense to recover the cost of an intangible asset, such as patents, goodwill and premium bonds.|
How to Calculate EBITDA
EBITDA is expressed in two ways:
EBITDA = Operating Profit + Depreciation Expense + Amortization Expense
Operating profit has already been decreased by the expenses from depreciation and amortization. By adding back these two expenses, you arrive at EBITDA, which is a larger amount than operating profit.
EBITDA = Net Profit + Interest + Taxes + Depreciation Expense + Amortization Expense
Net profit has already been reduced by the interest, taxes, depreciation and amortization. By adding these four terms back, you arrive at EBITDA.
To work out an example, let's use the following excerpts from a business's annual income statement.
|Cost of goods sold||$(4,000,000)|
|Taxes (at 21%)||$(525,000)|
EBITDA calculated the first way is:
- EBITDA = Operating Profit + Depreciation Expense + Amortization Expense
- EBITDA = $3 million + $700,000 + $300,000 = $4 million
EBITDA calculated the second way is:
- EBITDA = Net Profit + Interest + Taxes + Depreciation Expense + Amortization Expense
- EBITDA = $1.975 million + $500,000 + $525,000 + $700,000 + $300,000 = $4 million
How Business Owners Can Interpret EBITDA
Business owners interpret EBITDA as an indication of a company's core profitability "undistorted" by the effects of noncash expenses (amortization and depreciation), financial decisions (interest) and accounting decisions (taxes). The logic involves these assumptions:
- Amortization and depreciation reduce profits but don't affect cash flows, so EBITDA is an improvement because it deals more closely with cash flows, and therefore it's more useful when evaluating solvency (the ability to pay bills).
- Interest results from a financial decision to borrow money. EBITDA doesn't penalize the profitability from operations arising from decisions on how to finance those operations.
- Taxes for the current year can often be manipulated by changing the timing of revenues and expenses so that some occur in other years. EBITDA removes this accounting effect to better reflect the current profits from operations.
EBITDA can be used by owners to compare their companies' operating prowess relative to their competitors' and industry averages. When compared with net profits, EBITDA highlights the impacts of managerial decisions regarding the purchase of assets, the accounting for revenues and expenses, and the decisions of how to finance the company—debt versus equity.
A company can make a positive argument to investors when net profits sag by pointing to a strong EBITDA, indicating that core operations are in good shape. A company with a strong EBITDA but weak net profits might be viewed as a good acquisition target, as the acquirer might be able to restructure the company's assets, financing and/or accounting policies and emerge with a profitable operating division.
From a lender's viewpoint, an owner can use a strong EBITDA when applying for a loan by arguing that it has a good ability to service debt (pay interest and repay principal). Lenders might compare a potential borrower's EBITDA to those of competitors, using it to detect any troubling trend of falling EBITDA over time.
Ways Business Owners Can Improve EBITDA
An owner can take certain steps to increase EBITDA.
- Replace leased assets with purchased assets. Lease payments reduce operating profits and EBITDA, whereas the depreciation from purchased assets reduces operating profits but increases EBITDA.
- Borrow money to finance operations. Financing via retained earnings or proceeds from the sale of stock do not create an interest expense. By borrowing money instead, the interest expense reduces taxable profits and taxes, while increasing EBITDA because you add back the interest expense.
- Recognize revenues this year but postpone expenses until next year. This will increase your current year taxable income and your tax expense. EBITDA increases because you add back a current tax expense larger than if you had recognized expenses this year and revenues next year, which would reduce your current tax expense.
Financial and Accounting Ratios That Use EBITDA
EBITDA is used in many of the same ratios that use operating profit and net profit. Three important ones are:
- Net Debt / EBITDA: A high ratio, starting in the 4 to 5 range, indicates a high degree of debt and an inability to take on additional debt needed to grow the business. The trend of this ratio over several periods indicates whether the company's debt burden has been increasing or decreasing.
- EBITDA / Sales: Known as EBITDA margin, this ratio indicates how much cash the company expects to receive after paying operating costs. It is most often used to compare different companies within the same industry.
- EBITDA / Interest Payments: This is an interest coverage ratio, in which a value greater than 1.0 indicates a company has enough profits to pay its interest expenses. It has less meaning if the company needs to use profits to replace old equipment.
EBITDA Pros and Cons
There are some pros to using EBITDA.
- It is easy to calculate using data readily available from the income statement.
- It highlights operating income by removing accounting, tax and depreciation/amortization variables.
- It accounts for those expenses necessary to run the company day-to-day.
- It can be compared to competitor and industry values.
There are cons to using EBITDA, too.
- It is not consistent with generally accepted accounting principles because "earnings" are meant to represent unadjusted net income.
- Companies can use inconsistent variations over time, such as EBIT (earnings before interest and taxes).
- It doesn't reflect changes in working capital requirements, i.e., the need for short-term cash.
- It rewards companies that have high expenses for taxes, interest, depreciation and amortization.
- It can be manipulated by management, as described earlier.