Being a measure of a company’s profitability of the operating business, attempting to master how to calculate EBITDA (formula and uses) is surely an attempt to bypass the effects of indebtedness, state-mandated payments, and costs required to maintain its asset base nonetheless.
Since no such attempt can ever be made without first having a grasp of the EBITDA meaning and understanding, this content is concentrated on placing clearly right before you as you patiently check through:
The Concept of EBITDA
The Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) is an alternate measure of profitability to net income. By stripping out the non-cash depreciation and amortization expense as well as taxes and debt costs dependent on the capital structure, EBITDA attempts to represent cash profit generated by the company’s operations.
Thus, it is net income (earnings) with interest, taxes, depreciation, and amortization added back. EBITDA can be used to track and compare the underlying profitability of companies regardless of their depreciation assumptions or financing choices. It is often used in valuation ratios, notably in combination with enterprise value as EV/EBITDA, also known as the enterprise multiple.
This great financial concept is especially widely used in the analysis of asset-intensive industries with a lot of property, plant, and equipment and correspondingly high non-cash depreciation costs. In those sectors, the costs that EBITDA excludes may obscure changes in the underlying profitability—for example, as for energy pipelines.
Meanwhile, amortization is often used to expense the cost of software development or other intellectual property. That’s one reason why early-stage technology and research companies use EBITDA when discussing their performance
EBITDA is not a metric recognized under generally accepted accounting principles (GAAP). Some public companies report EBITDA in their quarterly results along with adjusted EBITDA figures typically excluding additional costs, such as stock-based compensation.
The earnings (net income), tax, and interest figures are found on the income statement, while the depreciation and amortization figures are normally found in the notes to operating profit or on the cash flow statement.
The usual shortcut for calculating EBITDA is to start with operating profit, also called earnings before interest and taxes (EBIT), then add back depreciation and amortization.
There are two distinct EBITDA formulas, one based on net income and the other on operating income. The respective EBITDA formulas are:
EBITDA = Net Income + Taxes + Interest Expense + Depreciation & Amortization
EBITDA = Operating Income + Depreciation & Amortization
Examples (Company XYZ accounts for their $12,000 depreciation and amortization expense as a part of their operating expenses. Calculate their Earnings Before Interest Taxes Depreciation and Amortization):
EBITDA = Net Income + Tax Expense + Interest Expense + Depreciation & Amortization Expense
= $19,000 + $19,000 + $2,000 + $12,000
EBITDA = Revenue – Cost of Goods Sold – Operating Expenses + Depreciation & Amortization Expense
= $82,000 – $23,000 – $19,000 + $12,000
Explanation of Some Parts of the Formula
Interest expense is excluded from EBITDA, as this expense depends on the financing structure of a company. Interest expense comes from the money a company has borrowed to fund its business activities.
Different companies have different capital structures, resulting in different interest expenses. Hence, it is easier to compare the relative performance of companies by adding back interest and ignoring the impact of capital structure on the business. Note that interest payments are tax-deductible, meaning corporations can take advantage of this benefit in what is called a corporate tax shield.
Taxes vary and depend on the region where the business is operating. They are a function of a jurisdiction’s tax rules, which are not really part of assessing a management team’s performance, and, thus, many financial analysts prefer to add them back when comparing businesses.
Depreciation & Amortization
Depreciation and amortization (D&A) depend on the historical investments the company has made and not on the current operating performance of the business. Companies invest in long-term fixed assets (such as buildings or vehicles) that lose value due to wear and tear.
The depreciation expense is based on a portion of the company’s tangible fixed assets deteriorating over time. Amortization expense is incurred if the asset is intangible. Intangible assets such as patents are amortized because they have a limited useful life (competitive protection) before expiration.
- EBITDA metric is commonly used as a loose proxy for cash flow. It can give an analyst a quick estimate of the value of the company, as well as a valuation range by multiplying it by a valuation multiple obtained from equity research reports, publicly traded peers, and industry transactions, or M&A.
- In addition, when a company is not making a net profit, investors can turn to EBITDA to evaluate a company. Many private equity firms use this metric because it is very good for comparing similar companies in the same industry. Business owners use it to compare their performance against their competitors.
- When comparing two companies, the Enterprise Value/EBITDA ratio can be used to give investors a general idea of whether a company is overvalued (high ratio) or undervalued (low ratio). It’s important to compare companies that are similar in nature (same industry, operations, customers, margins, growth rate, etc.), as different industries have vastly different average ratios (high ratios for high-growth industries, low ratios for low-growth industries).
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