Back to Basics: How to Calculate EBITDA
There are lots of acronyms to know in the world of divestments. EBITDA is one of the most important. Here's what you need to know.
EBITDA is an oft-used but controversial measure that cut its teeth during the leveraged buyout frenzy of the '80s. EBITDA is ubiquitous in financial circles and is regularly used to value businesses, compare companies within an industry, and set loan covenants. Although the metric is seemingly straightforward, it is a "non-GAAP" measure that requires care with its use.
It is a measure of operational performance and excludes impacts by non-operating expenses such as non-cash expenses (amortization and depreciation), interest, and taxes.
How EBIDTA Is Calculated
EBIDTA is short for Earnings Before Interest, Taxes, Depreciation, and Amortization. Depending on your starting point, the calculation for EBITDA is as follows:
- EBITDA = Operating Profit + Depreciation + Amortization
- EBITDA = Net Income + Interest + Taxes + Depreciation Expense + Amortization
Where the definitions of the individual terms are as follows:
- Net Income: The amount of revenue remaining after subtracting all expenses such as costs of goods sold, SG&A, depreciation, amortization, financing costs, and taxes.
- Operating profit: Profit earned from operations. The amount of revenue remaining after subtracting expenses such as costs of goods sold, SG&A, depreciation, and amortization.
- Interest: Financing costs on outstanding debt.
- Taxes: Income tax expense for the period.
- Depreciation: Non-cash expense for the portion of a tangible fixed asset, such as a building or equipment, considered consumed in the current period.
- Amortization: Non-cash expense similar to depreciation, except it refers to intangible assets. Intangible assets include patents, trademarks, copyrights, and goodwill.
EBITDA is used in several ratios and calculations, but one useful metric is EBITDA Margin. EBITDA Margin is EBITDA as a percentage of revenue and can be interpreted as how much operating cash is generated for each dollar of revenue earned.
EBITDA Margin is regularly used for comparing companies in the same industry with a higher EBITDA margin being better than a lower one.
History of EBITDA
As the saying goes, necessity is the mother of invention, and the birth of EBITDA was no different. During the '70s, cable billionaire John Malone was fully aware that the key to future profitability in the cable business required scaling operations to control programming costs. However, he had to contend with both a problem and an opportunity.
During that time, Wall Street and many cable operators focused on net income and earnings per share (EPS) growth. John Malone's growth strategy was at odds with EPS growth because it required minimizing reported earnings and taxes to maximize pretax cash flow to fund organic growth and acquisitions. He found his solution by emphasizing cash flow to lenders and investors with the use of EBITDA.
EBITDA provided preferable optics for heavily levered and capital-intensive companies. It displayed higher profitability than operating profit or net income. Through a series of adjustments to net income, EBITDA measures operating performance that is considered undistorted by particular accounting or financial strategies. EBITDA highlights operating performance, which suits certain types of business structures.
EBITDA's popularity with investors as a measure of value continued to grow in the '80s and beyond. In the '80s, leveraged buyout investors used EBITDA to assess distressed businesses' profitability and gauge whether the acquisition targets could cover financing costs upon restructuring. During the dot-com heydey, EBITDA was a favored metric in identifying companies ready for growth but weighed down by heavy debt loads.
How EBITDA Is Used
Today, EBITDA continues to be valuable in evaluating a company's operating performance by business owners, investors, and lenders alike.
Business owners and managers use EBITDA to compare their firm's operating performance to competitors and industry averages. A strong EBITDA can help secure business loans since it provides information regarding debt servicing. Finally, a high EBITDA margin can court potential buyers by signaling the company has healthy cash flow and is likely profitable.
Investors use EBITDA as a quick metric to assess operations, compare a target against other investments within its industry, and get a feel for its valuation. Strong EBITDA but weak net profits might be a good acquisition target if the investor can restructure the target's assets and debt.
Lenders use EBITDA to compare the borrowers operating performance to competitors. It also provides a view into cash with the logic that if EBITDA is healthy, operating cash flow will follow. Furthermore, EBITDA provides a view into the ability to repay loans. Finally, EBITDA is regularly used in the formulation of debt covenants.
Advantages and Disadvantages
Although EBITDA is utilized throughout the financial landscape, one must understand the strengths and weaknesses of EBITDA or risk a misleading picture of a company's financial situation.
Advantages of EBITDA
- EBITDA can easily be calculated using information from the income statement.
- EBITDA highlights operating performance by removing the impact of accounting, tax, and financing decisions. Depreciation, amortization, tax, and interest do not affect operating performance, and they can vary between companies. Interest can vary by capital structure. Tax expense can differ by jurisdiction and doesn't have much to do with a company's operations. Finally, depreciation and amortization are non-cash expenses that are subjective and don't affect operations as well.
- EBITDA can compare a company to its competitors and industry averages.
Disadvantages of EBITDA
- EBITDA is a non-GAAP measure, and its calculation might not be consistent and potentially manipulated.
- EBITDA isn't a substitute for cash flow. For instance, EBITDA doesn't incorporate changes in working capital and capital expenditures.
- EBITDA benefits companies with high taxes, interest, and depreciation/amortization. This can potentially shift focus away from poor management decisions, including taking on high-interest debt or failing to replace aging equipment.
- EBITDA ignores the cost of assets and assumes that profitability is a function of sales and operations alone.
EBITDA can be a useful metric for gaining better insight into a company's finances, but care needs to be taken when analyzing. EBITDA is one piece to the puzzle, and multiple metrics are required to develop a full picture of a company's situation.