There are many financial metrics to evaluate the profitability of a company. These metrics help to measure the overall financial performance of a company and determine the efficiency of a business’s operations. A commonly used measure of profitability is EBITDA.
EBITDA means earnings before interest expense, taxes, depreciation, and amortization. These earnings are devoid of any effect of capital structure, tax structure, and certain accounting policies. This is because EBITDA only takes into consideration those factors that are a result of core business activities.
Let us understand more about EBITDA, its interpretation, why to use it, and how to calculate EBITDA.
Understanding EBITDA in detail
The EBITDA metric allows a company and its stakeholders to determine its long-term profitability, and its ability to pay off future financial obligations. It basically shows the financial performance of a company, without accounting for the capital and tax framework of a business. The purpose is to eliminate those factors that are influenced by particular business decisions and external variables.
Companies are not legally required as per GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards) to disclose this information specifically in their financial statements. However, it can be easily ascertained by looking at a company’s income statement.
Let us understand each term involved in EBITDA to further get knowledge of this measure.
Components of EBITDA
- Earnings: It refers to the net income that a company makes in a period of time. This value can be easily determined by subtracting operating expenses from the revenue earned by a company.
- Interest: Interest varies from company to company. It is dependent on the capital structure and financial obligations of a company. So interest is added back to the net income of the company to derive a figure that is compatible with inter-firm comparison.
- Taxes: Tax is an expense that is not in the hands of a business, i.e., it is an extraneous factor. It may depend from country to country and even region to region. Since it does not affect business operations and management in any way, it is added back to the net income of the company for a better industry comparison.
- Depreciation: Depreciation is a non-cash expense that refers to the decrease in the value of tangible assets over their lifespan. Such assets are long-term, fixed assets like machinery, property, buildings, vehicles, etc.
- Amortization: It refers to the eventual expiration of an intangible asset like patents, trademarks, goodwill, etc. Like depreciation, amortization is also a non-cash expense.
What is a Good EBITDA?
Since EBITDA measures the financial performance and profitability of a business, the higher the value of EBITDA, the better it is. To know if the value of a company’s EBITDA is actually good or not, you can compare the EBITDA of a business with its peers, or the industry average.
How to Calculate EBITDA?
The formula for calculating EBITDA is as follows:
EBITDA = Net Income + Interest expense + Taxes + Depreciation + Amortization
and/or,
EBITDA = Operating Income + Depreciation + Amortization
Steps to Calculate EBITDA
Look at a company’s income statement
An income statement is a record of a company’s income and expenses in an accounting period. It consists of all relevant information required to calculate EBITDA.
Identify relevant figures
From the income statement, find the net income of the company. Next, find out the interest and tax liabilities of the business from the non-operating expenses sub-heading. Depreciation and amortization expenses can be ascertained from the operating expenses sub-heading of the income statement. They can also be acquired from the cash flow statement of the company.
Calculate EBITDA
By adding interest, tax, depreciation, and amortization to the net income of a business, you’ll arrive at its EBITDA. Alternatively, you can also calculate EBITDA by adding depreciation and amortization to the operating income of the company for the concerned period. Operating income is the net revenue generated by a firm from its day-to-day activities.
Example of EBITDA
Below is the income statement of Infosys Ltd. for the year ended March 31, 2021.
- Calculating Infosys’ EBITDA using net income:
| Particulars | ₹ (in crores) |
| Net Income | 18,048 |
| Interest (Finance cost) | 126 |
| Tax expense (Current tax + Deferred tax) | 6,429 |
| Depreciation & Amortization expense | 2,321 |
| EBITDA | 26,924 |
Uses of EBITDA
EBITDA as a financial metric, has a variety of uses such as
Determining Cash Flow
EBITDA is useful in determining a business’s cash flow. So if a company has negative EBITDA, it means that the company has poor cash flow. However, a positive EBITDA is not always a guarantee of strong profitability.
Evaluating A Company
EBITDA is one of the most important measures that investors should consider while valuing a company. It provides a fair view of how a business is operating, by eliminating external variables like taxes, finance costs, and non-cash expenses, that do not have any real effect on its cash flow, such as amortization and depreciation.
EBITDA is also used in calculating the debt service coverage ratio (DSCR), a debt-to-income ratio, used to measure the cash flow of a company, and its ability to pay off its debt obligations.
Reliable Measure
Being a reliable measure of profitability, EBITDA enables a company’s stakeholders to focus thoroughly on the base profit of a company. Hence, it is a better indicator of the financial position of a firm. EBITDA is a useful measure for deciding whether to buy, sell or invest in a business.
Peer Comparison
Since EBITDA neutralizes the impact of capital structure, tax structure, and accounting policies on a business, it can be used to compare companies against one another. EBITDA provides a clear picture of how a business is performing against its industry competitors.
EBITDA vs Net Income, Operating Income
Net income is the bottom line figure in the income statement of a firm. It is arrived at after deducting all sorts of expenses incurred by a business from its revenue (operating as well as non-operating). On the other hand, EBITDA is just net income with finance costs and tax expenses added back to it.
EBITDA is a variation of the operating income of a firm (EBIT). It excludes non-cash as well as non-operating expenses.
EBIT = Net income + Interest Expense + Tax Liabilities
As can be seen above, EBIT takes into account depreciation and amortization expenses. That is, it considers the monetary value of the fixed assets of a company. So, for companies with a large asset base, the EBIT measure is a better indicator of profitability.
Shortfalls of EBITDA
Like every coin has two sides, the same goes for EBITDA. Even though it is a great measure of profitability, it does omit to take into consideration a few factors that cannot be ignored.
Not Legally Mandated
EBITDA is not legally recognized by GAAP or IFRS as a measure of financial performance. This is because different companies use different components to arrive at the value of EBITDA, depending on the nature of their business and the expenses they incur.
Ignores Working Capital & Monetary Value of Assets
Working capital requirements are not taken into consideration by EBITDA. It considers the profit made by selling a product/service, but it fails to account for the changes in working capital.
Moreover, EBITDA shows assets at historical value, and not their actual present-day value, as depreciation and amortization are added back to profit to calculate this measure. So if a company has been acquiring a lot of fixed assets, that too via debt, then EBITDA will fail to show the actual impact this situation will have on a company’s profitability.
Different Starting Points
Since EBITDA is not legally mandated by GAAP or IFRS, companies interpret this metric and its formula at their convenience. They use different starting points to calculate EBITDA. Hence, EBITDA can be easily manipulated by management to present a better picture of the firm, whereas, in reality, the result might be far from the truth.
Misleading Results
As mentioned above, EBITDA can paint a false picture of a business, that can mislead its external stakeholders. When depreciation and amortization expenses are added back to net profit, it may show the company’s earnings to be greater than they actually are. Also, many companies use different accounting methods to provide for depreciation, and they can easily manipulate depreciation schedules of assets to inflate their profit projections.
Conclusion
EBITDA is a useful metric in determining how much cash a company generates. It can be used by analysts, investors, and management of the company to make intra-firm as well as inter-firm comparisons. It is a helpful tool in determining the cash flow and value of a business. However, one should also keep in mind the various drawbacks of this value, and accordingly make an informed decision.