What is EBITDA?

Earnings before interest tax depreciation and amortization(EBITDA)

EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation, and Amortisation, is an additional metric for determining net income profitability. It eliminates the capital structure-dependent non-cash costs of debt, taxes, and amortisation and depreciation.

The earnings before interest, taxes, depreciation, and amortization (EBITDA) measure makes an effort to show the cash profit produced by the business' operations.

EBITDA is a powerful tool for analyzing your business and identifying the next steps to keep your company successful.

EBITDA was developed in the 1980s to assess whether a company could service its debt in the future. Occasionally, this metric is applied to assess companies in financial distress who need restructuring. Over the years, EBITDA has spread throughout various industries and applications. Let’s learn EBITDA meaning before moving on to specifics.

EBITDA Definition

EBITDA measures profitability before interest, taxes, depreciation, and amortisation. To represent cash profit generated by the company, EBITDA strips out non-cash expenses such as depreciation and amortisation, taxes, and debt costs.

EBITDA is a method of calculating earnings that excludes costs that a company cannot control, such as interest expenses and debt finance, taxes, and depreciation, among others. For investors, this is a good tool for comparing the viability and attractiveness of different-sized companies in a given industry.

Generally, companies calculate their cash flow by determining their EBITDA. This is one of the most important indicators of the health of a company.

When deciding how much money to lend to a business, banks and other financial professionals use EBITDA. Although they may use other metrics, EBITDA is consistently reliable and consistent.

Depending on the situation, EBITDA can either be positive or negative. It's considered healthy for a company to have positive EBITDA for a prolonged period. However, even profitable companies can experience negative EBITDA periods.

However, neither IFRS nor US GAAP recognizes EBITDA as a metric. Warren Buffet, for example, disdains this metric because it doesn't account for asset depreciation. For example, if a company owns a large amount of depreciable equipment (and incurs high depreciation expenses), EBITDA does not consider maintenance and sustainment costs.

History of EBITDA

Liberty Media Chairman John Malone is one of very few investors with track record that can compete with Warren Buffett's. He is creator of EBITDA. statistic was developed in 1970s by pioneer of cable industry to support his leveraged growth plan, which involved using debt & reinvested profits to reduce taxes, to lenders & investors.

EBITDA was helpful to lenders & investors in leveraged buyouts (LBOs) in 1980s in determining whether targeted company could afford to pay back debt that was anticipated to be incurred in acquisition. It seemed appropriate to deduct interest & tax expense from earnings because takeover would probably result in changes to capital structure & tax obligations.

Depreciation & amortization expenses are non-cash charges that, at least initially, will not have impact on company's capacity to pay down its debt.

The EBITDA-to-interest coverage ratio, which compares core operating profitability as measured by EBITDA against debt service expenses, is of particular interest to LBO buyers, who typically target businesses with short-term capital investment plans.During dotcom bubble, some companies inflated their financial performance using EBITDA, which led to its notoriety.

In 2018, WeWork Companies Inc., shared office space provider, submitted prospectus for its initial public offering (IPO) that defined its "Community Adjusted EBITDA" as removing sales & marketing expenses in addition to general & administrative costs. This caused further negative attention for metric.
 

EBITDA Formula and Calculation

Now that we’ve covered “what does EBITDA mean,” let’s learn how to calculate it. You can calculate EBITDA using two formulas, the first using operating income, and the second using net income.

Using Operating Income

Here is the first formula:

EBITDA = Operating Income + Depreciation + Amortisation

The operating income of a company is the profit after subtracting the daily operating costs. Investors can determine the company's operating performance by excluding interest and taxes from operating income. A business' operating income shows how much money it makes from its operations.

A company's operating income is typically calculated by subtracting sales from operating expenses, such as the cost of goods sold and wages. As operating income is already accounted for before interest and taxes, calculating EBITDA is only a matter of adding D&A.

Using Net Income

EBITDA can also be calculated using the following formula:

EBITDA = Net Income + Taxes + Interest Expense + Depreciation + Amortisation

For the second formula, net income is used instead of operating income, which is calculated by adding back taxes and interest expenses. A company's income statement contains net income, tax expense, and interest expense, just like operating income.

Components of the formula:

The following are the components of the formula:

1. Interest is the cost that businesses incur as interest rates fluctuate or loans are repaid.
2. Direct, indirect, and state taxes are included in taxes.
3. The depreciation expense refers to the non-cash cost of maintenance and wear and tear on an asset.
4. The amortization of intangible assets spreads the cost over the asset's life, which can be predetermined. Copies, patents, agreements, contracts, and organization costs could be a part of these assets.

How EBITDA Works With Leveraged Buyouts

A leveraged buyout (LBO) is the purchase of a publicly or privately held company, whether it is a standalone company or a subsidiary of a larger company, using borrowed funds to pay for the purchase. After a leveraged buyout transaction is complete, a private equity firm (also called a financial sponsor) or group of private equity firms (also known as a consortium or private equity group) takes ownership (owns the equity) of the company.

Lenders and investors engaging in leveraged buyouts (LBOs) in the 1980s used EBITDA to measure profitability to determine whether the target companies could meet the debt required for the acquisition. With a buyout inevitably resulting in a new capital structure and tax liabilities, excluding interest and taxes from earnings made sense. A depreciation or amortization expense is non-cash and will not affect the company's debt service ability.

As a result, knowing a target company's EBITDA can give you an idea of its purchase price, how much you might be able to borrow against it as collateral, and even what you might be able to profit from if the company's operations (in terms of EBITDA) demonstrated improvement. If used correctly, EBITDA can be a very useful metric.

In summary, lenders operating in the LBO space look at EBITDA as one of the key factors when making lending decisions. Therefore, EBITDA is often used to quote loans and covenants.

EBITDA vs. EBT and EBIT

Definition of EBIT

As the name suggests, a company's earnings before interest and taxes (EBIT) is a method used to analyse profit without considering tax expenses or the cost of capital structures.

EBIT=Net Income+Interest Expense+Tax Expense

Definition of EBT

The term Earnings Before Tax (EBT) refers to a company's profit before paying corporate income taxes. This calculation was primarily used to estimate the business's profit without considering varying tax rates.

EBT = Earnings before interest and taxes (EBIT) – interest expense

EBITDA vs. EBIT

While EBIT and EBITDA remove debt financing costs and taxes, EBITDA adds back amortization and depreciation expenses. Since we don’t include depreciation in EBITDA, we can use it to compare operating results between companies with different amounts of fixed assets.

The EBIT of a company with high fixed assets is lower than that of a company with low fixed assets because of higher depreciation. The benefit of EBITDA is that it compares the performance of two organisations before depreciation is taken into account.

The terms EBIT and operating income are sometimes used interchangeably, but they are often different (depending on the company). EBIT includes gains and losses from non-core activities, including equipment sales and investment returns, but operating income does not.

EBITDA vs. EBT

Also, EBITDA differs from earnings before taxes (EBT), which measures operating profits before taxes are taken into account. Adding taxes back into net income calculates a company's EBT.

Investors can use EBT to measure a firm's operational performance after removing tax liabilities. Despite their similarities, EBT and EBIT differ in the inclusion of interest expenses in their calculations.

EBITDA vs. Operating Cash Flow

Using operating cash flow is a better way to measure a company's cash flow since it includes changes in working capital, including receivables and payables that use or provide cash. It also includes non-cash charges (amortisation and depreciation) back to net income.

A company's working capital trends play an important role in determining how much cash it generates. In analysing working capital and relying only on EBITDA, investors may miss clues, such as difficulties collecting receivables, that could affect cash flow.

Examples of EBITDA

This is an excerpt from Company XYZ's Income Statement as of 30th March 2021.

Depreciation and amortization of the company amounted to Rs. 63,00,700 as per Cash Flow Statement.

So the EBITDA of XYZ for the Financial Year 2020-2021 would be,

EBITDA = Net Income + Interest +Taxes +Depriciation + Amortisation

=Rs (20,15,36,900 + 5,10,000 + 1,10,99,200 + 63,00,700)

=Rs 31,84,46,800

It is worth noting that even the slightest error in the values of these components can significantly impact a firm's profitability. A reliable accounting system and keeping finances up-to-date are crucial to preventing the same.

What Is a Good EBITDA?

EBITDA measures a company's profitability, so higher numbers are generally better. A "good" EBITDA gives investors a better understanding of a company's performance without losing track of the fact that it excludes cash expenses for interest, taxes and eventual replacement of tangible assets.

What Is Amortisation in EBITDA?

Amortisation is process of gradually discounting book value of organization's intangible assets to generate EBITDA. income statement shows amortization. Among intangible assets are intellectual properties like patents & trademarks, as well as goodwill, which is difference between past acquisition costs & their fair market value.

Is EBITDA the Same as Profit?

No, EBITDA & profit are not same.  EBITDA indicator measures company's profit before taxes, depreciation, & amortisation, while net profit indicator measures its total earnings after taxes, depreciation, & amortization.

EBITDA Advantages

These tips provide concise overview of its main benefits.

• It provides trustworthy synopsis of company's expansion & efficiency of its operating approach.
• Significantly less risk exists for variables that frequently influence financial variables, such as capital investment.
• It displays true worth of cash flow produced by ongoing business operations.
• EBITDA solely takes into consideration costs that are necessary to maintain business's daily operations.
• Comparing company's financial efficiency against that of its peers is helpful. 
• A company's attractiveness as target for leveraged buyouts is indicated by its EBITDA. 
• Since company's debt is not transferred when it is sold, method used to finance company is typically ignored.

EBITDA Disadvantages

The following are some of disadvantages of EBITDA: -The final figure is seen misleading because loan expenses are not included in EBITDA. information worth of company's liquid assets or actual earnings is not disclosed.

• It is often used by business owners as cover for their bad financial decisions & weaknesses in finance department.
•  High-interest debt is unaffected by it.
• When evaluating company's financial performance, depreciation & EBITDA amortization are not taken into account as actual costs.
• In order to obtain more realistic financial picture, companies must employ several financial indicators in addition to EBITDA.

Because it accounts for extraneous influences, EBITDA is useful metric for assessing company's fundamental profit patterns. However, investors & business owners must employ other, more inclusive financial measures in order to arrive at more thorough financial analysis.
 

What is EBITDA Coverage Ratio?

A financial indicator called EBITDA-to-interest coverage ratio, or EBITDA coverage ratio, is used to evaluate financial capability of company. It looks at whether pre-tax profits would cover company's interest-related costs. 

EBITDA Coverage Ratio = (EBITDA + Lease Payments)/(Interest Payments + Principal Payments + Lease Payments) is formula for calculating EBITDA coverage ratio.

A result larger than 1 or 1 indicates that firm in issue is probably in strong financial situation. It also implies that company has financial capacity to pay back its debts. 

It should be mentioned that EBITDA coverage & EBITDA-to-interest coverage ratio are not same thing. For example, whereas latter employs more comprehensive EBITDA, interest coverage ratio uses earnings before income & taxes.
 

The limitations of EBITDA

Here are a few drawbacks of EBITDA:

●  A company's EBITDA cannot be substituted for analysing its cash flow. EBITDA can give the impression that they have more money for interest payments than they really do.

●  Furthermore, EBITDA makes a company's earnings appear cheaper than they really are by disregarding the quality of its earnings.