What Is EBITDA?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a measure of a company’s operating performance and profitability before factoring in expenses related to capital structure and tax liabilities.
EBITDA is calculated by taking a company’s net income and adding back interest, taxes, depreciation, and amortization expenses. It attempts to represent the earnings and cash flow generated by a company’s core operations, excluding non-operational factors and non-cash items.
How Does EBITDA Work?
EBITDA aims to provide a normalized view of profitability that can be used to compare companies across industries. It eliminates variables related to debt financing, tax jurisdictions, and accounting assumptions to focus solely on the business’s operating earnings.
The key elements of EBITDA are:
- Earnings: This is the net income or net profit produced by the firm after all operating expenses are deducted. The calculation of EBITDA starts with this metric as the base.
- Interest: By adding back the interest paid on debt, EBITDA nullifies the impact of different capital structures.
- Taxes: Since tax rates and regulations vary widely from one country or industry to the other, EBITDA removes this variable by adding back taxes.
- Depreciation: This non-cash expense is dependent on accounting methods, so EBITDA adds it back.
- Amortization: Similar to depreciation, this non-cash expense is excluded by adding it back to the firm’s net income.
Adding back these expenses aims to represent the company’s cash-flow generation capacity based solely on its operations and production activities.
Types of EBITDA
There are several variations on EBITDA, including:
- Adjusted EBITDA: Adds back additional expenses like stock compensation and restructuring costs.
- EBITDAR: Also adds back rent costs. It is often used to evaluate the profitability of retail stores.
- EBITDARM: Further adds back royalty fees and marketing expenses. It is mostly used in the hospitality industry.
- EBITDAC: Adds back the costs related to customer acquisition. It is used by subscription businesses mostly.
How to Calculate EBITDA With an Example
Here is an example of how to calculate EBITDA:
Let’s say that Company X published the following figures in its latest quarterly financial statement:
- Revenue: $500 million
- Cost of goods sold: $200 million
- Operating expenses: $50 million
- Depreciation and amortization: $20 million
- Operating profit: $230 million (Revenue – COGS – Overhead = $500m – $200m – $50m = $230m)
- Interest expense: $10 million
- Taxes: $66 million.
- Net income: $154 million (Earnings before taxes x (1 – Tax rate) = $220m x (1 – 30%) = $154m)
To calculate EBITDA, the following formula must be used:
EBITDA = Net Income + Taxes + Interest + Depreciation & Amortization
EBITDA = $154 million + $66 million + $10 million + $20 million = $250 million
So, by using these different figures, the EBITDA of Company X would be $250 million after adding back all of these non-cash and cash expenses to the firm’s net income.
Pros and Cons of EBITDA
Advantages of EBITDA:
- Allows analysts to compare the profitability of various companies regardless of their industry.
- Eliminates the impact of the business’s capital structure, taxes, and accounting policies when analyzing the performance of different businesses.
- It is a closer estimation of the company’s cash-flow generation capacity compared to net income.
Disadvantages of EBITDA:
- EBITDA may not be the most relevant metric for shareholders.
- It can obscure warning signs like high debt levels.
- It does not account for the impact of capital investments or asset depreciation on the business’s financial performance.