EBITDA is net income before interest, taxes, depreciation, and amortization. It is a method of gauging the success of a business by tracking the money it earns from its various endeavors.
Here is how EBITDA functions, why businesses and investors use it, and its disadvantages.
The primary elements of EBITDA
Since it eliminates the effects of debt financing, cost structure, inflation, and royalties, EBITDA is the most all-encompassing statistic by which a company's cash flow can be analyzed, and is therefore widely used by businesses, investors, lenders, and other stakeholders to assess a company's success. In other words, it gives a general estimate of how much a company can make before paying off its debts to lenders and the government and reinvesting the money into the company.
EBITDA's primary constituents are:
Profit or earnings reflects the remaining amount after subtracting interest, funding firm growth, and covering vendor costs.
When a company borrows money or sells bonds to raise capital, it must pay interest on those loans or bonds.
Taxes are the costs that arise from having to hand up a cut of the business's earnings to various levels of government, both domestic and international.
The cost of the fixed assets is amortized over the years that they are in use, a process known as depreciation. Assets depreciate over time as their value decreases.
Amortization is the gradual write-down of an intangible asset's initial investment over its useful life span. Typical examples of intangible assets include goodwill and intellectual property.
EBITDA is calculated by deducting operating income from net income and then adding it back together with other cash flows to get a snapshot of a company's cash flow.
When calculating a company's profitability, business owners should look at EBIT, which considers all operating expenses but excludes financing charges (i.e., interest expense). Expenses for depreciation and amortization can be subtracted from operating income to arrive at EBITDA.
Why businesses employ EBITDA
Different stakeholders in a business utilize EBITDA in several ways. Thus it's helpful to have a standard manner of talking about a company's performance:
Lenders: EBITDA is a metric that lenders may use to assess how much cash flow is available to pay down debt.
Stock market analysts and investors: EBITDA can be used as a basis for valuation metrics like enterprise value divided by EBITDA and can also be used to gauge a company's debt load. The technique is also used to compare and contrast various companies.
Company executives: EBITDA can help managers determine how much cash they have to invest, issue and redeem debt, and make other capital allocation decisions.
EBITDA, however, is not a reliable indicator of a company's profitability and can be a misleading tool.
The shortcomings of EBITDA
EBITDA is widely used as a proxy for cash flow in the business world, but it has several significant drawbacks that make it a less reliable indicator.
EBITDA is not a standardized accounting concept (GAAP)
Many businesses do not utilize EBITDA as an official measurement because GAAP does not recognize it. In practice, this implies that businesses may use multiple definitions of EBITDA and that some may adjust their calculations to include "one-time" costs, giving the impression that they are more profitable than they are.
For instance, EBITDA frequently includes "one-off" costs that most people would classify as operating costs, like one-time legal fees, executive remuneration based on stock options, and other personnel costs. Profitability may be overstated when EBITDA or "adjusted EBITDA" is used.
EBITDA disregards finance.
Some analysts have doubted its value as EBITDA does not consider the cost of servicing a company's debt. A sole reliance on EBITDA may provide an inaccurate picture of a company's operations because it evaluates profitability without considering how it is financed.
If two businesses, for instance, have comparable EBITDA, but one uses significantly more debt financing than the other, the interest expense will be significantly higher. Even though they might have the same EBITDA, the debt will cause their after-tax profits to be considerably different.
EBITDA disregards the effects of taxes.
EBITDA, as the name implies, does not include tax costs. Therefore, the statistic excludes any tax the company may have paid, which, of course, could affect its profitability.
Investing is not taken into account by EBITDA.
While depreciation and amortization are typically factored back into a company's bottom line, the EBITDA formula ignores the importance of these expenditures in keeping a business competitive. It may be possible for a company to delay making investment cuts for a few years during tough times, but ultimately, it will need to make cuts to stay in business.
