EBITDA is the acronym for Earnings before Interest, Taxes, Depreciation and Amortization and is calculated just that way-Earnings before Interest and Taxes + Depreciation + Amortization. It can also be calculated by taking Net Income and adding back Interest + Taxes + Depreciation + Amortization. EBITDA has become a widely used metric to obtain a better understanding of a company’s profits and it’s operating performance. EBITDA is not included on most native financial reports generated from Xero or Quickbooks Online. Generally, you will need to perform the calculation above to determine your company’s EBITDA for each reporting period. Some financial reporting packages do include EBITDA, but there is usually some customization required.
So what are the benefits in using EBITDA and what are the drawbacks? There are definitely both so it’s important to keep in mind that there isn’t a single measurement that investors, company owners or an industry can rely on solely in evaluating financial performance. Because EBITDA isn’t defined or governed by GAAP, it can be calculated in slightly different ways by companies. EBITDA excludes depreciation and amortization because both are considered non-cash items. However, both depreciation and amortization are indicators of what a company is spending to maintain and grow its business. When using EBITDA to measure the value of a company, any decrease in value of fixed assets is not accounted for and earnings would be overstated. Therefore, it’s recommended that stakeholders use other financial metrics in addition to EBITDA. In doing so, they will get a more complete picture of a company & its earnings. Three important metrics to use when evaluating business performance are EBITDA, return on equity (“ROE”) and return on assets (“ROA”).
Perhaps the main reason for EBITDA’s popularity is that it excludes some of the more discretionary or subjective expenses incurred by a company as a result of management’s decisions. Interest expense is the result of how a company is financed which is a choice by the owners. Debt or equity can be used to finance a company and EBITDA excludes the consideration of equity or debt financing. Taxes are also added back to earnings because there are situations that may be non-recurring in a year which drive taxes down or lead to an increase. It is an expense that can fluctuate every year and certainly differ between companies when doing a comparison. Depreciation and amortization are also considered subjective because management determines the useful life for each of its assets. Companies may have different depreciation policies which could lead to different net income results based on management’s assumptions related to the useful life of capital assets.
EBITDA is often used as a tool to measure a company’s worth in a merger or acquisition transaction. When a company buys another company, it is often buying the assets of that company and not its debt. The selling company’s debt is not of great concern to the buyer unless the buyer is assuming the debt.
The buyer will make decisions going forward as to how it may finance the company and therefore is less concerned with the seller’s debt structure. Below is a comparison of two companies and using the EBITDA metric, it shows which company is the better investment.
Revenues
$10,000.00
Cost of Goods Sold
$6,000.00
Int Expense
$0.00
Depreciation Expense
$1,000.00
Income before Taxes
$3,000.00
Net Income (26% tax)
$2,220.00
EBITDA
$4,000.00
Revenues
$10,000.00
Cost of Goods Sold
$6,000.00
Int Expense
$1,000.00
Depreciation Expense
$1,000.00
Income before Taxes
$2,000.00
Net Income (26% tax)
$1,480.00
EBITDA
$4,000.00
In this example, Business A has higher Net Income but EBITDA is the same for both businesses. Business B is financed with debt, incurs interest expense and thus has lower Net Income. Essentially, Business A & Business B have the same acquisition value and would be a good investment to an investor. This example helps to show how EBITDA can be a useful tool when comparing the financial health of two companies. It is strongly encouraged, though, that this calculation is used in conjunction with other financial metrics. In doing so, an investor will obtain a more complete and clear picture of a company & its earnings.
Feel free to chat with one of our professionals to better understand EBITDA and how important this metric is for your particular business.
