What is EBITDA?
EBITDA, or earnings before interest, taxes, depreciation, and amortization, is a measure of a company’s operational profitability that excludes costs associated with debt and non-cash charges. By removing these elements, EBITDA aims to provide a clearer view of the cash profit generated purely by a company’s core business operations.
Although EBITDA is widely used for assessing corporate profitability, it is not recognized under generally accepted accounting principles (GAAP). However, many public companies report EBITDA, including adjusted EBITDA figures, which often exclude additional costs like stock-based compensation.
Key Takeaways
- Comprehensive Measure: EBITDA captures the core profitability of a business by adding back interest, tax, depreciation, and amortization to net income.
- Easy Calculation: This metric can be easily derived from a company’s financial statements.
- Debate Among Experts: Critics argue that EBITDA can overstate profitability by ignoring significant expenses such as depreciation and capital costs. For instance, Warren Buffett dismisses EBITDA as a “meaningless measure of performance”.
- Regulatory Compliance: The U.S. Securities and Exchange Commission (SEC) mandates reconciling EBITDA figures with net income and prohibits reporting EBITDA on a per-share basis.
How to Calculate EBITDA 🚀
If a company doesn’t report EBITDA directly, you can calculate it using financial statement data:
- Formula:
- From Net Income:
EBITDA = Net Income + Taxes + Interest Expense + Depreciation + Amortization - From Operating Income:
EBITDA = Operating Income + Depreciation + Amortization
- From Net Income:
To get these values, refer to the income statement, cash flow statement, or financial statement notes. Both methods effectively isolate the cash-generated profitability of a company.
What EBITDA Reveals 👀
By stripping out interest, taxes, depreciation, and amortization, EBITDA focuses on a company’s operational efficiency. It is widely used in industries with significant physical assets and high non-cash depreciation expenses. This measure is particularly valuable when comparing companies’ underlying profitability across different sectors and business models.
Early-stage tech and research firms also favor EBITDA to reflect operational performance devoid of the heavy impact from R&D expenses and development costs.
Paul Moored succinctly encapsulated this in his influential accounting principles: depreciation reflects the unavoidable wear of your primary tools, and EBITDA is a momentary respite, excluding these inexorable financial duties.
Inspirational Example 📈
Imagine a company that generates $100 million in revenue. With $40 million in the cost of goods sold (COGS) and $20 million in overhead, the operating profit stands at $30 million. After subtracting $5 million in interest expenses, earnings before taxes are $25 million. Applying a tax rate of 20%, net income ends at $20 million post a $5 million tax deduction.
By adding back depreciation ($10 million), interest expense ($5 million), and taxes ($5 million), we derive an EBITDA of $40 million.
| Amount | |
|---|---|
| Net Income | $20,000,000 |
| Depreciation and Amortization | $10,000,000 |
| Interest Expense | $5,000,000 |
| Taxes | $5,000,000 |
| EBITDA | $40,000,000 |
History and Evolution of EBITDA 🌎
EBITDA was pioneered by Liberty Media Chairman John Malone in the 1970s, primarily to attract lenders by minimizing tax implications and emphasizing cash flow. It gained prominence in the 1980s for leveraged buyouts (LBOs), and misuse during the dotcom bubble in the late ’90s highlighted the importance of responsible valuation.
EBITDA’s reputation took a hit in 2018 when WeWork’s IPO prospectus redefined it to exclude significant operational expenses, drawing severe criticism.
Criticisms of EBITDA 🙅♂️
- Ignorance of Asset Costs: EBITDA neglects costs for both tangible and intangible assets, distorting the portrayal of profitability.
- Valuation Concerns: Heavy emphasis on adjusted profits can mislead investors and obscure true valuation metrics, leading to deceptive financial health portrayals.
Alternative Metrics 🌟
- EBIT (Earnings Before Interest and Taxes): Provides a closer look at profitability by excluding interest and taxes but including depreciation and amortization.
- EBT (Earnings Before Tax): Focuses on profit before tax, offering additional clarity for state or federal tax variances.
Operating Cash Flow is often deemed a more accurate indicator of cash profits by incorporating working capital adjustments along with depreciation and amortization.
Closing Thoughts 💬
EBITDA remains a robust metric when utilized alongside thorough financial analysis. While it strips non-cash and non-operational expenses to spotlight core business profitability, investigators need to scrutinize its application closely. Insightful evaluation necessitates contextual understanding and reconciliatory maths ideal for a potential investor’s toolkit.
Related Terms: Net Income, Depreciation, Amortization, EBIT, EBT.
References
- U.S. Securities and Exchange Commission. “Non-GAAP Financial Measures”.
- Berkshire Hathaway. “2000 Annual Report”. Pages 17, 65.
- Moody’s Investors Service. “Putting EBITDA in Perspective”. Page 3.
- Harvard Business Review. “How EBITDA Can Mislead”.
- U.S. Securities and Exchange Commission. “WeWork Companies Inc. Form S-1”.
- Berkshire Hathaway. “2000 Annual Report”, Page 17 (Page 18 of PDF).
