EBITDA, an acronym for “earnings before interest, taxes, depreciation, and amortization,” is an often-used measure of the value of a business. EBITDA is calculated by taking net income and adding interest, taxes, depreciation, and amortization expenses back to it. EBITDA is used to analyze a company’s operating profitability before non-operating expenses (such as interest and “other” non-core expenses) and non-cash charges (depreciation and amortization).
Analysis with EBITDA
EBIDTA enables analysts to exclude the impacts of non-operating activities and focus on the outcome of operating decisions. Non-operating activities include interest expenses, tax rates, and large non-cash items such as depreciation and amortization.
By removing the non-operating effects, EBITDA gives investors the ability to focus on the profitability of their operations. This type of analysis is particularly important when comparing similar companies across a single industry.
Limitations of EBITDA
Factoring out interest, taxes, depreciation, and amortization can make even completely unprofitable firms appear to be fiscally healthy. The use of EBITDA as a measure of financial health made these firms look attractive. EBITDA numbers are easy to manipulate. If fraudulent accounting techniques are used to inflate revenues and interest, taxes, depreciation, and amortization are factored out of the equation, almost any company may appear to be profitable and great.
Operating cash flow is a better measure of how much cash a company is generating because it adds non-cash charges (depreciation and amortization) back to net income and includes the changes in working capital that also use or provide cash (such as changes in receivables, payables, and inventories). These working capital factors are the key to determining how much cash a company is generating. If investors do not include changes in working capital in their analysis and rely solely on EBITDA, they will miss clues that indicate whether a company is losing money because it isn’t making any sales.
Despite various shortcomings, there are some good reasons for using EBITDA.
- The first factor to consider is that EBITDA can be used as a shortcut to estimate the cash flow available to pay the debt on long-term assets, such as equipment and other items with a lifespan measured in decades rather than years. Dividing EBITDA by the number of required debt payments yields a debt coverage ratio. Factoring out the “ITDA” of EBITDA was designed to account for the cost of the long-term assets and provide a look at the profits that would be left after the cost of these tools was taken into consideration.
- Another factor is that EBITDA estimate to be reasonably accurate, the company under evaluation must have legitimate profitability. Using EBITDA to evaluate old-line industrial firms is likely to produce useful results. This idea was lost during the 1980s when leveraged buyouts were fashionable, and EBITDA began to be used as a proxy for cash flow. This evolved into the more recent practice of using EBITDA to evaluate unprofitable dotcoms as well as firms such as telecoms, where technology upgrades are a constant expense.
- EBITDA can also be used to compare companies against each other and against industry averages. In addition, EBITDA is a good measure of core profit trends because it eliminates some of the extraneous factors and allows a more “apples-to-apples” comparison.
Ultimately, EBITDA should not replace the measure of cash flow, which includes the significant factor of changes in working capital. Remember “cash is king” because it shows “true” profitability and a company’s ability to continue operations.