EBITDA is an acronym. It stands for Earnings Before Interest, Taxes, Depreciation and Amortisation.
EBITDA is a financial figure designed as a more transparent alternative to others on a financial statement, such as net income or total earnings.
Ultimately, it shows a company’s ability to generate cash – in other words, its ability to pay its debts.
How is EBITDA calculated?
Let’s first look at the four terms that matter for EBITDA:
- Interest, for example, on bank loans and financing from third parties.
- Taxes, anything and everything a business pays to local and national revenue departments.
- Depreciation – an ‘expense’ that arises as the value of a fixed asset (such as a car) decreases over time.
- Amortisation – the gradual process of periodically expensing part of the cost of an intangible asset (like a patent, trademark etc.).
All of the above are financial figures, and all are combined with net income to produce EBITDA. Therefore:
EBITDA = net income + interest + taxes + depreciation and amortisation expenses
Sometimes, this is shortened to:
EBITDA = operating profit + depreciation and amortisation expenses
Why is EBITDA used over other figures?
The people who matter often prefer it.
Businesses often have to look attractive to individuals like owners, buyers and investors. These people will frequently seek the EBITDA figure because they feel it gives them more information about a company’s health.
What’s so special about EBITDA?
It puts the spotlight on the company’s business decisions.
If you analyse cash flow after taxes, interest and depreciation/amortisation, you’re analysing a figure subject to significant outside influence that management can’t control. In these cases, it’s harder to see how well the company has performed.
EBITDA developed as an answer to this problem. It shows finances before taxes, interests and depreciation/amortisation; and therefore omits any outside influence on finances. What’s left is a more direct indication of how much money the company has made.
This makes it easier to answer two questions:
- Is the company profitable?
- Are its business decisions paying off?
Any other advantages of EBITDA?
- It makes it easier to see whether a firm can pay debts
- It makes it easier to see the total value of a company
- It makes it easier for evaluation purposes when a company is not making a profit
- It makes it easier to compare companies against each other, even across industries.
What should boards know about it?
If you’re on a board of directors, you should know the following about EBITDA:
- It is extremely popular as a metric, championed for how clearly it demonstrates profitability.
- You can calculate it easily from financial statements, which, as a board member, you should be able to understand.
- Critics, however, say that EBITDA is meaningless because it omits capital costs and presents a false summary of a company’s finances.
As a result, it has widespread yet informal popularity. It is not part of generally accepted accounting principles (GAAP), and some countries have laws limiting its use.