What is EBITDA—EBITDA Full Form
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It is another way to measure a company’s profitability, different from net income. Companies use EBITDA to show how well they are performing financially.
EBITDA is not recognized by Generally Accepted Accounting Principles (GAAP). However, some public companies include it in their quarterly reports. They may also show adjusted EBITDA, which excludes extra costs like stock-based compensation.
As companies and investors focus more on EBITDA, some critics argue that it makes a company’s profitability seem better than it is. The U.S. Securities and Exchange Commission (SEC) requires companies to explain how they calculate EBITDA from net income. The SEC also doesn’t allow companies to report EBITDA per share.
History of EBITDA
John Malone, the Chairman of Liberty Media, created EBITDA. He came up with the idea in the 1970s to help convince lenders and investors to support his strategy. This strategy used debt and reinvested profits to reduce taxes.
Use in Leveraged Buyouts (LBOs)
In the 1980s, investors and lenders involved in leveraged buyouts (LBOs) started using EBITDA to determine whether a company could handle the debt that would come from the acquisition.
Since LBOs often changed a company’s capital structure and tax liabilities, excluding interest and tax expenses from earnings made sense. Depreciation and amortization were also excluded because they didn’t affect a company’s ability to pay off debt in the short term.
Popularity in the Dotcom Bubble
EBITDA became widely known during the dotcom bubble. Some companies used it to make their financial performance seem better than it actually was.
Controversy with WeWork
EBITDA got more negative attention in 2018 when WeWork filed for an initial public offering (IPO). They defined their “Community Adjusted EBITDA” by excluding general, administrative, sales, and marketing costs. This raised concerns about how the metric was being used.
What Does EBITDA Really Tell You?
EBITDA helps to understand a company’s true profitability. Here’s how it works:
a. Excludes Interest, Taxes, Depreciation, and Amortization
EBITDA shows a company’s core earnings by removing the above-mentioned items from net income. This makes it easier to compare companies, regardless of how they handle financing or depreciation.
b. Used in Valuation
EBITDA is often used in financial ratios, like the EV/EBITDA ratio (enterprise value divided by EBITDA). This ratio helps investors assess a company’s value.
c. Useful in Certain Industries
Asset-heavy industries: Companies in sectors like energy or manufacturing, which own a lot of property and equipment, often use EBITDA. These industries have high non-cash depreciation costs, which EBITDA excludes.
Technology and research companies: Early-stage companies in these fields use EBITDA because it excludes amortization costs, which are related to intellectual property like software development.
d. Focus on Operational Profit
Taxes and interest depend on external factors (like debt levels or tax laws) and may not reflect how well the business is actually performing. EBITDA focuses on the cash profits generated by the company’s main operations by excluding these factors.
However, not everyone agrees with using EBITDA. For example, Warren Buffett, CEO of Berkshire Hathaway, has criticized EBITDA. He argues that depreciation is a real cost that shouldn’t be ignored. According to him, EBITDA doesn’t provide a full or meaningful picture of a company’s performance.
How to Calculate EBITDA?
Calculating EBITDA is simple, which is one of the reasons it’s a popular way to measure profitability. Analysts can calculate EBITDA even if the company doesn’t report it directly.
EBITDA is usually calculated using the company’s income statement and cash flow statement. The income statement provides information on earnings, taxes, and interest. The cash flow statement shows depreciation and amortization. Analysts use both to calculate EBITDA.
A simple method for calculating EBITDA is to start with the company’s operating profit, also known as earnings before interest and tax (EBIT). Then, you add depreciation and amortization.
There are two easy formulas for calculating EBITDA:
- EBITDA = Net profit + Interest + Tax + Depreciation + Amortization
- EBITDA = Operating Income + Depreciation + Amortization
Both formulas work well, but the second one is a quicker method.
Example of EBITDA
Let’s look at a simple example to understand EBITDA.
- Revenue: The company makes $100 million in revenue.
- Costs: The company spends:
- $40 million on the cost of goods sold (COGS)
- $20 million on overhead costs
- Operating Profit: After deducting costs, the company has an operating profit of $30 million.
- Interest Expense: The company pays $5 million in interest.
- Earnings Before Taxes: This leaves $25 million in earnings before taxes.
- Taxes: The company pays $5 million in taxes. After taxes, the net income is $20 million.
Now, to calculate EBITDA, we add back:
- Depreciation and Amortization: $10 million
- Interest Expense: $5 million
- Taxes: $5 million
So, EBITDA equals $40 million.
Breakdown:
- Net Income: $20,000,000
- Depreciation & Amortization: +$10,000,000
- Interest Expense: +$5,000,000
- Taxes: +$5,000,000
- EBITDA: $40,000,000
Benefits of EBITDA
EBITDA is a key metric used to evaluate a company’s true value. Here’s why it’s important:
1. Shows the Real Value of a Company
EBITDA helps you understand a business’s core value by removing the effects of capital financing, taxes, and capital depreciation. This gives a clearer picture of the company is performance in its day-to-day operations.
For example, suppose two companies in the same industry have different tax rates or financing structures. In that case, EBITDA makes it easier to compare their true operational performance.
2. Helps Valuation Analysts and Investors
EBITDA is widely used by analysts, investment bankers, and private equity investors when valuing or buying a business. It helps assess a company’s ability to generate cash flow, which is crucial for sustainability and delivering returns to shareholders.
For instance, if an investor is looking at two potential acquisitions, they might prefer the one with higher EBITDA, as it shows better cash flow generation.
3. Reflects Operating Performance
EBITDA focuses on how well the company is running its operations, excluding expenses that aren’t directly related to day-to-day business, such as interest payments, taxes, and asset depreciation.
4. Simple Measure of Cash Flow
EBITDA provides a clear picture of the cash generated by a company’s ongoing operations. It shows how much cash the company is producing before paying for things like taxes or interest on debt.
5. Indicates Profit Potential
EBITDA shows how much profit a company is making from its operations before other financial factors come into play. This can help evaluate a company’s ability to generate profit in the future.
For example,if a company has high EBITDA but low net income, it suggests that the company has strong operational profits but might have high taxes or interest expenses.
6. Allows Easy Comparison Between Companies
EBITDA is useful for comparing companies within the same industry. Removing factors like debt and taxes shows which company is performing better operationally.
If one company has $50 million in revenue and $10 million EBITDA, and another has $60 million in revenue and $8 million EBITDA, the second company might have better profitability despite lower revenue.
7. Simple to Calculate
EBITDA is easy to calculate, making it a straightforward tool for understanding a company’s basic profitability. The formula is simple and easy to apply to financial statements.
Drawbacks of ETIBDA
EBITDA is a popular financial measure, but it has several drawbacks. Here are some of the main criticisms or limitations of ETIBDA
1. Different Calculations
Since EBITDA is not a standard measure under GAAP, each company can calculate it in different ways. This means companies can adjust it to look better by highlighting EBITDA over net income.
Example: A company might emphasize EBITDA to hide poor net income or other financial struggles.
2. Red Flag for Investors
If a company that hasn’t used EBITDA before suddenly starts using it, this can be a warning sign. It might indicate the company is facing problems, like rising debt or high development costs, and is using EBITDA to distract from these challenges.
3. Ignores Asset Costs
One of the biggest criticisms of EBITDA is that it doesn’t account for the cost of assets. Some people mistakenly believe that EBITDA represents cash earnings, but it doesn’t. It overlooks expenses related to assets, like capital expenditures or debt financing.
Example: Warren Buffett famously questioned, “Does management think the tooth fairy pays for capital expenditures?” This highlights that EBITDA ignores the real costs of running the business.
4. Unreliable Earnings Figures
The way companies calculate EBITDA can vary, depending on which earnings figures they start with. This makes EBITDA vulnerable to manipulation, especially since companies can play with the numbers on their income statement to make things look better.
5. Can Mislead About Company Value
EBITDA excludes many costs, which can make a company appear cheaper than it really is. When analysts use EBITDA to calculate stock price multiples, they might get lower numbers, leading to inaccurate conclusions about the company’s value.
Example: In 2006, Sprint Nextel’s stock was trading at 7.3 times its forecast EBITDA, which seemed like a good deal. However, the multiple was much higher when looking at the company’s operating profits. The stock was actually overvalued, even though the EBITDA figure made it look cheaper.
6. Can Lead to Wrong Valuations
Using EBITDA alone to assess a company’s value can be misleading. It doesn’t always reflect the company’s true financial health. In some cases, companies have been overvalued because EBITDA ignored important costs and risks.
Hedge fund manager Daniel Loeb warned that adjusted EBITDA and earnings can lead to misvalued companies, and this issue still exists today.
In short, while EBITDA can be useful, it should be used carefully. Investors who rely solely on EBITDA might not get an accurate picture of a company’s financial health.
EBITDA vs. EBIT vs. EBT
These three financial metrics are often used to measure a company’s profitability, but they differ in terms of what expenses they exclude or include. Below is a comparison table to highlight the key differences between EBITDA, EBIT, and EBT.
EBITA vs EBITDA
Frequently Asked Questions
What is the meaning of EBITDA?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is used to measure a company’s core profitability by focusing on its earnings from regular operations, excluding the effects of interest, taxes, and non-cash expenses like depreciation and amortization.
How to Calculate EBITDA Percentage?
To calculate EBITDA percentage (also called EBITDA margin), you need to:
- Divide the EBITDA by the company’s total revenue.
- Multiply the result by 100 to get the percentage.
What is a Good EBITDA Margin by Industry?
A good EBITDA margin can vary between industries, but in general, a margin of 15% or more is considered favorable.
Factors affecting EBITDA margin include:
- Industry: Different businesses have different operational costs.
- Company size: Smaller companies may have lower margins, while larger companies may have higher margins.
- Competition: Highly competitive industries may see lower margins.
- Regulations: Businesses that face strict regulations may experience higher costs, affecting margins.
What is Amortization Meaning in EBITDA?
Amortization in EBITDA refers to the gradual reduction in the value of a company’s intangible assets like patents, trademarks, and goodwill. It’s an accounting process that is recorded on the company’s income statement.
How to Calculate EBITDA from Gross Profit?
To calculate EBITDA from gross profit, follow these steps:
- Start with gross profit.
- Subtract all operating expenses from the gross profit to get the operating income.
- Add back depreciation and amortization expenses to the operating income to get EBITDA.
Formula:
EBITDA = (Gross Profit – Operating Expenses) + Depreciation + Amortization
Is EBITDA the Same as Gross Profit?
No, EBITDA and gross profit are different financial measures, although they are related. Here’s how they differ:
Gross Profit
- Calculated as revenue minus the cost of goods sold (COGS).
- Shows the profitability of a company’s core operations, excluding other costs.
- Focuses solely on the direct costs associated with producing goods or services.
EBITDA
- Stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.
- Provides a broader view of operational performance by excluding interest, taxes, depreciation, and amortization.
- Offers insights into a company’s profitability from its core activities, removing non-operating expenses and non-cash items.
While both metrics measure profitability, EBITDA provides a more comprehensive view of a company’s operating efficiency.
What are the Applications of the EBITDA Formula?
The EBITDA formula is widely used by businesses to assess performance and value across various areas:
- Corporate Profitability: EBITDA helps estimate a company’s profit by excluding certain expenses like taxes and interest, providing insight into its financial health.
- Competitive Standing: By comparing EBITDA with competitors, businesses can identify strengths and weaknesses and craft strategies to gain a competitive edge.
- Core Profit: EBITDA offers a clearer picture of a company’s core business performance by focusing on operational profits, excluding one-time items.
- Cash Flow: EBITDA aids in calculating cash flow, showing how much cash a company generates or owes, and helps in understanding the movement of money related to expenses, investments, and sales.