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EBITDA
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Earnings before interest, taxes, depreciation and amortization (EBITDA) is a non-GAAP metric that can be used to evaluate a company's profitability.
EBITDA = Operating Revenue – Operating Expenses + Other Revenue
Its name comes from the fact that Operating Expenses do not include interest, taxes, or amortization. EBITDA is not a defined measure according to Generally Accepted Accounting Principles (GAAP) and thus can be calculated however a company wishes.
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Encyclopedia
Earnings before interest, taxes, depreciation and amortization (EBITDA) is a non-GAAP metric that can be used to evaluate a company's profitability.
EBITDA = Operating Revenue – Operating Expenses + Other Revenue
Its name comes from the fact that Operating Expenses do not include interest, taxes, or amortization. EBITDA is not a defined measure according to Generally Accepted Accounting Principles (GAAP) and thus can be calculated however a company wishes. It is also not a measure of cash flow.
EBITDA differs from the operating cash flow in a cash flow statement primarily by excluding payments for taxes or interest as well as changes in working capital. EBITDA also differs from free cash flow because it excludes cash requirements for replacing capital assets (capex). EBITDA is used when evaluating a company's ability to earn a profit, and it is often used in stock analysis.
Use by debtholders
EBITDA measures the cash earnings that may be applied to interest and debt retirement. Debt holders ignore depreciation and amortization because they are non-cash charges and thus do not interfere with a company's ability to repay debt. Additionally, such figures are merely a reconciliation of cash-basis accounting to accrual-basis accounting and are subject to a certain degree of flexibility corporate accountants have when setting depreciation and amortization schedules.
In practice, capital expenditures and the maintenance of assets may use up cash available for debt repayment, and so will increase risk of default. The risk may be mitigated by incorporating loan covenants restricting the borrower's ability to make certain expenditures or investments under certain conditions.
There are two EBITDA metrics used.
- The interest coverage ratio is used to determine a firm's ability to pay interest on outstanding debt. It is calculated : EBITDA /Interest Expense. The greater the year-to-year variance in EBITDA, the greater the multiple should be.
- The measure of the pay-back period for a debt is : Debt/EBITDA. The longer the payback period, the greater the risk.
The ratios can be customized by reducing Debt by any cash on the balance sheet or by deducting maintenance CapEx from EBITDA to form a measure closer to free cash flow.
Use by equity owners
A company's Net Income is distorted by decisions that the company made in previous years. This is because of the differences between accrual accounting and cash basis accounting. Some purchases are depreciated or amortized over 20 years or more, with a negative impact on the Net Income long after the actual economic effects of the purchases have ceased. The EBITDA does not suffer this distortion, so investors can get an idea of how profitable the company really is.
Depreciation of capital expenditures is a particularly strong factor. For example, if a company spends $99 million in new desktop computers for all its employees, the company will often decide to depreciate the purchase over their expected lifetime of three years. This way, in the first year, when the company calculates its "income" number, it shows only $33 million in expenditure that year on desktop computers. The company's income number excludes money actually spent, but that will be "used" in future years. In each of the second and third years, the company also shows $33 million in expenditures per year on desktop computers. During this latter period, the cash expenditures have already been made, but a portion of that spending is allocated to these later periods.
Capital expenditures typically vary from year to year. Accrual accounting accounts for this by spreading the expense of capital investments over the years in which they will be generating value for the company. EBITDA strips out the effect of irregular capital expenditures. Investors can use EBITDA to approximate the fundamental earning power of the company's operations while separately factoring in the projected capital expenditures needed to maintain those operations. This is valuable because of the time value of money principle. (An expenditure is less costly if it is to be made several years into the future, because during the interim period the firm can use the cash for that expenditure to generate income in other ways. This is true as long as inflation is ignored. Oftentimes a capital expenditure today will cost much less than the same required expenditure at some point in the future simply because of inflation.)
Because EBITDA is measured before interest (which vary with the amount of debt financing), it approximates the company's earnings potential as if financed with zero debt. It corrects for the differences between companies' valuations due to their capital structure.
Warren Buffett famously asked, "Does management think the tooth fairy pays for capital expenditures?" For many companies, capital expenditures (for example) may be required at a consistent level; excluding the associated accounting allocation may overstate the company's profitability. Similarly, amortization (goodwill is no longer amortized since the 2002 change; it is now tested for impairment each year) may reflect important changes in the company's business prospects.
The same argument applies to the purchase of long-life capital assets. Depreciation may be interpreted as:
- the allocation of the original cost, at a later date, when the asset was used to generate revenue. The time-value-of-money (same argument used above) means that depreciation may understate the cost.
- the amount of cash required to be retained in order to finance the eventual replacement asset. Since inflation is the basis for time-value-of-money, the amounts set aside today must be invested and grow in value in order to pay the inflated price in the future.
- the decrease in value of the balance sheet asset since the last reporting period. Assets wear out with use, and will eventually have to be replaced.
Unprofitable businesses
When comparing businesses with no profits, their potential to make profit is more important than their Net Loss. Since taxes on losses will be misleading in this context, taxes can be ignored. Capital expenditures and their related debt result in fixed costs. These are of less importance than the variable costs that can be expected to grow with increasing sales volume, in order to cover the fixed costs. So depreciation and interest costs are of less importance. It is likely that an unprofitable business is burning cash (has a negative cash flow), so investors are most concerned with "how long the cash will last before the business must get more financing" (resulting in debt or equity dilution).
EBITDA is not used as a valuation metric in these circumstances. It is a starting point on which future growth is applied and future profitability discounted back to the present. Equity owners only benefit from net profits, after all the expenses are paid.
During the dot com bubble companies promoted their stock by emphasising either EBITDA or pro forma earnings in their financial reports, and explaining away the (often poor) "income" number. This would involve ignoring one-time write-offs, asset impairments and other costs deemed to be non-recurring. Because EBITDA (and its variations) are not measures generally accepted under U.S. GAAP, the U.S. Securities and Exchange Commission requires that companies registering securities with it (and when filing its periodic reports) reconcile EBITDA to net income in order to avoid misleading investors.
See also
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