In the 1980s, leveraged buyout investors created a new business metric called EBITDA. They were looking for a way to determine if the target company of a buyout would have enough cash flow to pay for the increased debt that would result from the purchase of the company. Although EBITDA served the purpose of promoting the feasibility of leveraged buyouts, it has many problems that are said to be deceptive and misleading.
What is EBITDA?
EBITDA is a financial tool that identifies the earnings of a company from its core business operations. It does not include expense deductions for interest paid to creditors, taxes paid to governments or non-cash deductions for depreciation and amortization. EBITDA is a calculation in dollars, not a ratio reported as a percentage.
EBITDA is the operating earnings of a company without regard to its debt structure, tax situation and methods of depreciation for capital equipment and buildings. It is intended to show how much a business earns exclusively from the manufacturing and selling of its goods and services.
How to Calculate EBITDA
Start with the net income figure for a company. Then, add back the amounts that the business deducted for taxes, interest, depreciation and amortization.
EBITDA = Net Income + Taxes + Interest + Depreciation + Amortization
Example of EBITDA Calculation
Take the income statement of hypothetical Company ABC, and use the above formula to compute EBITDA.
ABC Company Annual Income Statement
- Revenues $1,000,000
- Operating Expenses:
- Salaries 500,000
- Rent 250,000
- Amortization 12,500
- Depreciation 37,500
- Earnings Before Interest & Taxes (EBIT) 200,000
- Interest Expense 25,000
- Operating Expense (Earnings Before Taxes) 175,000
- Taxes 50,000
- Net Income 125,000
To find EBITDA, take Net Income ($125,000), and add back Taxes ($50,000), Interest Expense ($25,000), Depreciation ($37,500) and Amortization ($12,500). From the formula above, we calculate EBITDA as follows:
EBITDA = $125,000 + $50,000 + $25,000 + $37,500 + $12,500 = $250,000
Analysis and Interpretation
Analysts use EBITDA to compare the profit performance of similar companies in the same industry. It minimizes the unique non-operating issues of each company and allows apples-to-apples comparisons. This is particularly important when comparing companies that operate in different tax brackets.
EBITDA is useful when analyzing the sale of a company or merger with another firm. By stripping away a firm's current financial and tax structure, bankers can get a better picture of the company's cash flow and ability to service the interest and principal payments resulting from a leveraged buyout.
Cautions and Limitations
Many analysts believe that EBITDA is not a reliable indicator of a company's performance and can be deceptive and not representative of a firm's true profits or its financial health. It is not defined as a term in GAAP; this allows companies to report EBITDA in a form most favorable to them since they don't have to comply with standard accounting principles.
A high EBITDA does not necessarily mean that the financial health of the company is good. The company could have a lot of debt on its books and be paying a high amount of interest. High-interest payments in relation to cash flow increase the financial risk of a business. Just looking at EBITDA would hide this risk; other metrics have to be considered to get a better gauge of the financial stability of a company.
EBITDA does not reflect fluctuations in working capital and is not a measure of cash flow. Cash flow and earnings are not the same thing and are calculated with two different accounting methods: cash and accrual. Since EBITDA is based on the accrual method, companies can artificially inflate their EBITDA by recording sales that have not been collected and converted to cash.
EBITA became popular in the 1980s when companies that specialized in leveraged buyouts began to use the term as a more accurate predictor of long-term profitability. The idea was to determine the true ability of a company to make a profit by stripping away all expenses that weren't directly related to the core operations of the business. However, like any financial metric, EBITDA should be used in conjunction with other measures and more detailed analyses because of the possibility of manipulation.