What Is EBITDA? (Video)
EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization, is a popular metric used for measuring a company's profitability. Some prefer EBITDA to net income because it can provide a more accurate representation of operating efficiency and is a good metric for comparisons with other companies.
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EBITDA can capture the operating efficiency of a company because the metric excludes non-operating expenses and certain non-cash items. The purpose of excluding these items is to analyze a company’s profitability without accounting for its capital structure.
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EBITDA Formula & How To Calculate
EBITDA = Net Income + Taxes + Interest Expense + Depreciation & Amortization
- Net Income: The “bottom line” on the income statement, net income is the net amount of money that a company earns after taking into account all expenses for the same period. Net income is a component of accrual accounting, where revenue or expenses are recognized when transactions occur, not necessarily when cash has been exchanged.
- Taxes: Corporate income tax is an expense on the income statement and is added back for EBITDA to gain a clearer picture of profitability.
- Interest Expense: Since companies tend to have different capital structures, interest expenses also tend to differ. For this reason, the interest expense is added back to make it easier to compare the relative performance of companies.
- Depreciation & Amortization: Depreciation and amortization are added back to the EBITDA calculation because they are non-cash expenses that don't often reflect an actual expense for the company.
Note: Net income, taxes, interest expense, and depreciation are all items found on the income statement. Depreciation and amortization are also found on the cash flow statement, as well as the balance sheet. These are the three main financial statements that publicly-traded companies are required to publicly disclose every quarter.
EBITDA Uses & History
EBITDA is a metric that is used to better understand a company’s performance compared to net income. Part of what makes EBITDA useful is that it includes costs from operations but not non-operating decisions, such as taxation and how a company is financed. This makes it easier to compare competing companies.
EBITDA is not a standard calculation required by GAAP (Generally Accepted Accounting Principles). For businesses with significant property, plant and equipment, or PP&E, EBITDA can vary widely from their GAAP net income due to the depreciation of PP&E. EBITDA is also helpful for large non-recurring items, such as mergers and acquisitions.
EBITDA first became widely used in the 1980s as a way for investors to assess distressed companies for leveraged buyouts. Today, the use of non-GAAP earnings in SEC filings is at a historically high level, according to the Corporate Finance Institute. In 1996, 59% of S&P 500 companies used at least one non-GAAP earnings measure. By 2018 97% of S&P 500 companies used at least one non-GAAP earnings measure in company filings.
Finding Company Valuation with EBITDA
EBITDA can be used in a calculation with enterprise value (EV) to find a company’s valuation. EV is the total value of a company and can be used as an alternative to market capitalization, or as a means of determining an acquisition price. Business valuation is often expressed in the financial industry in terms of a multiple, such as 8x EBITDA or 10x EBITDA.
Investors can use EV/EBITDA, which is a ratio that compares the total value of a company to the amount of EBITDA it earns on an annual basis. To find EV, add outstanding debt to market capitalization, then subtract available cash. The EV/EBITDA ratio can then be calculated by dividing EV by EBITDA.
EBITDA vs. EBIT
EBIT stands for earnings before interest and taxes. The difference between EBIT and EBITDA is that EBITDA adds back depreciation and amortization expenses and EBIT does not. As a result, EBITDA often gives a better indication of the cash flow profitability of a firm, since depreciation and amortization do not represent cash outflows.
While both EBITDA and EBIT start with net income, EBITDA may be preferred when analyzing or comparing companies with a large amount of fixed assets.
Using EBITDA vs. Net Income: Pros & Cons
While EBITDA can provide investors with a clear picture of a company’s financial performance, investors should take into consideration the pros and cons of EBITDA:
Pros
- Capital structure neutral: Can demonstrate a company’s financial performance without accounting for its methods of capital structure.
- Cash flow analysis: Displays cash flow attributed to a company’s ongoing operations.
- Comparison tool: Can provide a big picture view when comparing growth and investment potential between competing companies to determine which is running their business better.
Cons
- Misleading: Some companies emphasize EBITDA over net income because it can distract from problem areas in the financial statements. For example, a business can add more years to its depreciation period to make profits appear better.
- Ignores cost of assets: EBITDA may not accurately reflect a company’s performance because it ignores the cost of debt by adding taxes and interest back to earnings.
- Ignores changes in working capital: Interest, taxes and capital expenditures can cause fluctuations in liquidity and cash flow.
EBITDA Examples
To better understand how EBITDA works, consider a simplified example of two businesses in the same industry with different capital structures. By using EBITDA, investors can gain a better understanding of the financial performance of each company, which may be a better investment, and why EBITDA can be a better metric than net income.
Company A
Revenue | $1,000,000 |
Cost of Goods Sold | $200,000 |
Interest Expense | $150,000 |
Depreciation | $50,000 |
Income Before Taxes | $600,00 |
Net Income | $300,000 |
EBITDA | $800,000 |
Company B
Revenue | $1,000,000 |
Cost of Goods Sold | $200,000 |
Interest Expense | $50,000 |
Depreciation | $50,000 |
Income Before Taxes | $600,000 |
Net Income | $400,000 |
EBITDA | $700,000 |
In the examples above, EBITDA can be calculated by adding Interest Expense and Depreciation back to Income Before Taxes. Company A and Company B have the same revenue but their capital structures differ (Company A uses more debt financing). In terms of net income, Company B may look more attractive, but Company A’s EBITDA reveals strength when adding back its higher interest expense.
What’s a Good EBITDA?
A good EBITDA when comparing the financial performance of two companies is generally a margin of 10% or more. In mergers and acquisitions, determining the purchase price is a key consideration, and EBITDA is an important metric, along with book value, enterprise value, and free cash flow.
Note: Keep in mind that EBITDA can be advantageous when comparing competing companies of similar size and industry; however, it is a non-GAAP metric that can be misleading. Therefore, investors are wise to use multiple metrics when analyzing companies for potential investment.
FAQs
What’s the difference between EBITDA and gross profit?
The difference between EBITDA and gross profit is that EBITDA represents earnings before interest, taxes, depreciation, and amortization, whereas gross profit is revenue minus the cost of goods sold. Both are a measure of profitability but EBITDA is used more often for comparing the financial performance between companies and industries.
What’s the difference between EBITDA and revenue?
The difference between EBITDA and revenue is that EBITDA is a measure of a company’s profitability after excluding non-operating expenses and certain non-cash items, whereas revenue is a measure of total sales and other income activities.
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