Demystifying EBITDA

Earnings before interest, taxes, depreciation, and amortization (EBITDA) is a measure of profitability (like net income and gross profit) designed to allow analysts to compare profitability between companies and industries.

Since EBITDA measures profit before the impact of interest expense, tax expense, depreciation, and amortization expenses with varying levels of financial leverage (debt), operating under different tax laws, EBITDA facilitates ‘apples-to-apples’ comparison between companies and different depreciation methods & assumptions. This popular measure of a company’s financial performance by eliminating the effects of financial leverage (debt), taxes, and capital investments (D&A expenses), EBITDA is viewed by many as a good indicator of the core operating profitability of a company.

EBITDA = Net Income + Interest expenses + Taxes+Depreciation& Amortization

EBITDA became a popular financial metric with the introduction of leveraged buyouts (LBOs) in the 1980s when it was used to indicate the ability of a company to service debt by leveraged buyout (LBO) firms and lenders. EBITDA/sales ratio, for example, can be used to find the most efficient operator in a particular industry. It can also be used to analyse and compare profitability trends of different companies across industries over time. Through such ratios as debt/EBITDA and EBITDA/interest expense, EBITDA is a popular proxy for a company’s ability to take on debt.

EBITDA has several shortcomings incorrectly used or a shortened measure of cash flow. It does not take into account a company’s:

➢ Interest payments

➢ Capital expenditures (investments in fixed assets – cash out)

➢ Working capital (day-to-day cash requirements needed for a company’s ongoing operations)

EBIDTA can be manipulated to show a desired level of profitability. However, since it ignores debt payments, taxes, and capital expenditures, it can be used by the companies as their primary level of profitability. However, this can be misleading after taking into account those three obligations and the companies may instead be losing money. In addition, EBITDA is an inappropriate metric to use in industries such as cable and telecom, transportation, and energy because they are very much capital-intensive.

EBITDA is a very useful measure of profitability. However, it must be used in the analysis of a company’s financial health with full awareness of its limitations and potential for misrepresentation.