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Although the U.S. Securities and Exchange Commission (SEC) doesn’t recognize EBITDA as being part of the Generally Accepted Accounting Principles (GAAP), some finance experts swear by it. Public companies are also reporting it in their SEC earnings filings.
EBITDA (a company’s Earnings Before Interest, Taxes, Depreciation, and Amortization) is one of the most widely-used metrics for valuation analysis and securities pricing analysis. In theory, EBITDA allows for a more refined analysis of a company’s profitability because non-operational expenses (expenses that don’t occur in the normal course of business) aren’t taken into account.
EBITDA is intended to be used to compare the profitability of different companies by discounting the effects of (1) interest payments from different forms of financing (by ignoring interest payments), (2) different political jurisdictions or parts of the world (by ignoring tax payments), (3) collections of assets (by ignoring depreciation of assets), and (4) different takeover histories (by ignoring amortization). This financial measurement of cash flow from operations is widely used in mergers and acquisitions and companies in the middle market (annual revenue between $100 million and $3 billion). It’s not uncommon for adjustments to be made to EBITDA to normalize the measurement so that buyers and investors can more easily compare the performance of one company to another. Essentially, buyers will then be able to “compare apples to apples”.
If a company has a negative EBITDA, this is an indication that there are fundamental problems with profitability and cash flow. It may be assumed that a positive EBITDA means a company is thriving and experiencing positive cash flow, but this isn’t necessarily the case. This is because EBITDA ignores changes in working capital, in capital expenditures, in taxes, and in interest.
When evaluating the profitability of a company, some finance experts are soured on the idea of omitting capital expenditures. They feel that capital expenditures are necessary for maintaining the company’s asset base which allows for earning a profit. Warren Buffett made this scathing remark about EBITDA as a measure of a company’s profitability, “Does management think the tooth fairy pays for capital expenditures?” He goes on to say he’s suspicious of accounting methodology that’s vague because it often means management is trying to hide something.
EBITDA has mostly been used to determine a company’s performance/profitability in the intrinsic sense (ignoring all costs that don’t occur in the normal course of business), which has resulted in too many cost items being considered as “outside of the normal course of business” and profitability being artificially boosted. Because EBITDA and its variations aren’t accepted under GAAP, the SEC requires companies who register securities with it (and when filing its periodic reports) to reconcile EBITDA to net income so that investors aren’t misled.
Knowing how to calculate and apply EBITDA is important to business owners and investors for two main reasons:
As discussed above, EBITDA helps in the analysis and comparison of the profitability between companies and industries as it disregards the effects of financing (interest expense), government decisions (income tax expense), and accounting decisions (depreciation and amortization expense). This provides a rawer, clearer view of a company’s earnings.
To get a better understanding of EBITDA, let’s look at some basic accounting principles. The conventional method for determining a company’s profitability is to calculate its net income. The straightforward definition of net income is gross revenue (every dollar earned) less expenses (every dollar spent).
When thinking of business expenses, most people think of manufacturing costs, the cost of raw materials or wholesale goods, utilities, employee wages, rent on office space, and other tangible costs of doing business. But tangible costs aren’t the only costs that companies incur. When a company borrows money, interest must be paid on the loans. Additionally, most companies are subject to taxation, and most companies use accounting practices like depreciation and amortization to spread the cost of large expenditures over a longer period of time.
According to GAAP, the conventional way of calculating net income (gross revenue less expenses) is the only acceptable way. However, in the 1980s, companies specializing in leveraged buyouts began to adopt EBITDA as a more accurate measure of sustainable profitability. They used EBITDA to quickly calculate whether these companies could pay back the interest on these financed deals. They contended that, by omitting costs that aren’t directly related to a company’s core operations (interest, taxes, depreciation, and amortization), EBITDA provides a purer measure of a company’s viability.
EBITDA can indeed be used to effectively compare two or more similar companies in traditional industries (i.e. retail, education). This financial measurement uses a simple calculation to arrive at a number that represents a company’s earning potential from its core business operations. Unfortunately, EBITDA has a history of being used by high-risk businesses in non-traditional industries to make a bad investment appear to be sound.
Calculating EBITDA is quite simple and there are two formulas often used. All information needed for both formulas is contained within the income statement. The first formula uses Net Income as the starting point. The first step in calculating EBITDA is to pull Net Income from the income statement. To arrive at Net Income, all of the company’s expenses were deducted. To arrive at EBITDA, interest expense, tax expense, depreciation expense, and amortization expense are added back to Net Income. Supposedly, the resulting figure (EBITDA) is an indication of the company’s cash flow or actual amount of cash contained within the company.
(Formula #1) EBITDA = Net Income + Interest + Taxes + Depreciation and Amortization
The second formula uses Operating Income as the starting point. Operating Income is a company’s profit after cost of goods sold and operating expenses are deducted, but before taxes and interest have been deducted). It helps investors separate out the earnings for the company’s operating performance by excluding interest and taxes.
Because depreciation and amortization expenses were already deducted from Operating Income, it’s necessary to add these “non-cash” expenses back to arrive at EBITDA. Many investors use this figure because they feel that the “non-cash” expenses have little impact on a company’s actual cash flow. Opponents of EBITDA feel differently about EBITDA being a reliable measure of a company’s financial strength and ability to repay debt, as you’ll later see.
(Formula #2) EBITDA = Operating Income + Depreciation and Amortization
Here’s an explanation of the key terms behind EBITDA calculations:
Amortization is an operating expense found on the income statement. It refers to charging or writing off an intangible asset’s cost as an operational expense over its estimated useful life to reduce a company’s taxable income. It’s similar to depreciation except that it’s used to assess the useful value of intangible assets (i.e. goodwill, patents, trademarks, and copyrights), whereas depreciation focuses on fixed tangible assets. Amortization is the portion of an intangible asset’s value that’s removed to recognize its diminishing effectiveness as an asset to the company.
Depreciation is an operating expense found on the income statement. Because a company’s fixed assets (i.e. buildings, equipment, vehicles) deteriorate with use, each year the decrease in value is removed from the asset’s fair value. Companies depreciate long-term assets for both accounting and tax purposes. The decrease in the asset’s value affects the company’s balance sheet, and the method of depreciating the asset, for accounting purposes, affects net income. On the income statement, it’s allocated as depreciation expense among the periods in which the asset is expected to be used.
Operating income is a company’s profit after cost of goods sold and operating expenses have been subtracted from revenue. It can also be stated as a company’s net income before interest and income tax expenses are deducted. Operating income is most widely used by investors and creditors to analyze a company’s performance from its core operations without tax expenses and capital structure costs skewing profit numbers.
Operating Income = Net income + Interest expense + Tax expense
Net income includes the deductions of interest expense and tax expense, so they need to be added back to net income to arrive at operating income.
On the income statement, interest expense generally represents the cost of borrowing money from banks, investors, and other sources. It’s the price the company pays for the use of the lender’s money. Interest expense relates to the capital structure of a company and is usually tax-deductible.
In business and accounting, net income is a measure of a company’s profitability. It’s a company’s income less cost of goods sold, expenses, interest and income taxes for a particular accounting period. Net income represents the balance after all expenses and losses for the period have been deducted from all revenues and gains for the period. It’s the final line item (“bottom line”) on the income statement.
An operating expense is an ongoing cost for operating a business. Day-to-day expenses such as salaries, rent, utilities, depreciation, and amortization fall under this category. Its counterpart, capital expenditure, is the money a company spends to buy or improve its fixed assets, such as buildings, vehicles, equipment, or land. It’s considered a capital expenditure when the fixed asset is newly purchased or when money is used towards extending the useful life of an existing asset. For example, the purchase of a company vehicle is a capital expenditure, whereas the cost of gas and oil used in the vehicle is an operating expense. On the income statement, “operating expenses” represents the sum of a company’s operating expenses for a particular period of time, like a month or year.
Taxes generally appear on a company’s income statement as Income tax expense, which is a non-operating expense. This figure reflects the tax obligation imposed by a federal, state, or local jurisdiction. Income taxes are calculated by applying the appropriate tax rate to the company’s income after allowable deductions have been taken.
In addition to touting EBITDA as a clean measure of financial performance, proponents feel that it has the following redeeming qualities:
When looking to buy or invest in a company, calculating its ability to make money is part of an entrepreneur’s or investor’s due diligence. The EBITDA formula makes it less complicated to evaluate the profitability of a company, which isn’t always easy. If you’re looking to invest in a company, you need to know if the current business model is effective. Assessing the company’s financial health is one way to determine that.
EBITDA can be used as a shortcut to estimate the cash flow available to pay long-term debt such as the financing of long-term assets like equipment and other assets with a lifespan of decades as opposed to years. A company’s debt coverage ratio can be calculated by dividing EBITDA by the number of required debt payments.
EBITDA can be used to compare companies against each other and industry averages. EBITDA is felt to provide a more precise assessment of a company’s operational performance because it disregards the expenses that don’t contribute to a company’s day-to-day operations, such as interest expense, income expense, and depreciation and amortization. By disregarding these expenses, EBITDA cancels out the effect of different accounting practices, like the use of different depreciation and amortization methods. It also cancels out the effect of tax authority mandates which can result in different tax obligations based on factors like industry, location, and company size. With these extraneous factors eliminated, a more reliable “apples-to-apples” comparison is possible.
While EBITDA may be a widely used metric for measuring a company’s financial strength (profitability and ability to repay debt), using it as a single measure of earnings or cash flow can be misleading. Companies can divert investors’ attention away from high debt levels and high expenses against earnings by lauding their EBITDA figures. Without adjustments being made to address debt levels and the expenses that EBITDA ignores (interest, taxes, depreciation, and amortization), the evaluation of a company’s financial health is incomplete. Here are four reasons to be suspicious of EBITDA:
One of the main problems with EBITDA is that some companies try to use it as a cash flow proxy (substitute for cash flow). On the surface, EBITDA resembles cash flow because it focuses exclusively on revenue generated from the daily operation of a business. But, earnings and cash flow are calculated using two completely different accounting methods. In accrual accounting, a sale is counted towards revenue as soon as the product ships to the customer. In cash accounting, the sale isn’t counted towards revenue until the customer pays for the product in full. EBITDA is based on accrual accounting numbers and doesn’t accurately reflect cash that the company has received – only what it has earned on paper. If a company spends money to manufacture a product and the product isn’t sold until a year later, the company may not have enough working capital for running its daily operations and to pay creditors. This can lead to further debt and the company being declared insolvent. If insolvency proceedings take place, the company’s assets may be liquidated to pay off outstanding debts.
Therefore, EBITDA is an acceptable proxy for profitability but NOT cash flow. It ignores working capital and cash requirements that are needed to fund capital expenditures, which may be sizeable depending on the nature of the company.
EBITDA also doesn’t take depreciation and amortization into account, two accounting methods used to spread out the expense of large capital investments. For a company just starting out, these capital investments can be hefty. Critics of EBITDA feel that ignoring the long-term financial impact of these investments is perilous.
Another reason that EBITDA is an inadequate indicator of cash earnings is that the actual cash flow of a company is directly affected by two of the things that EBITDA disregards: interest and taxes. Interest and taxes are real, non-optional expenses and should be considered when evaluating a company’s ability to repay debt. Companies must service their loans (pay interest) and they must pay taxes to their government (before they can even pay dividends to investors) or they won’t be in business for long. The cash to cover these two cost items has to come from somewhere.
EBITDA’s tendency to ignore changes in working capital (the cash needed to cover day-to-day operations) is most problematic in cases of fast-growing companies. These companies require increased investment in receivables and inventory to convert their growth into sales. Those investments of working capital consume cash, but EBITDA neglects them. If a company breaks even under EBITDA, it still may not generate enough cash to replace the routine capital assets it uses in the business. Therefore, treating EBITDA as a cash flow proxy gives investors incomplete information about cash expenses. If investors want a more reliable measure of a company’s cash position, they need to refer to the cash flow statement.
The proponents of EBITDA as a measure of financial strength applaud its simplicity — interest payments, tax payments, depreciation, and amortization are subtracted from earnings to arrive at EBITDA. Seems straightforward enough, but what about the fact that companies use different earnings figures as the starting point for EBITDA? When that’s considered, the EBITDA methodology doesn’t allow for “comparing apples to apples”.
Because EBITDA adds depreciation and amortization expenses back to earnings, it can easily make a company look like it has more cash than it does and that it will be able to make interest payments. For example, if a company has $15 million in operating profits and $22 million in interest charges and depreciation and amortization totaling $11 million are added back, the company would then have EBITDA of $26 million. It would appear that the company has enough money to cover its interest payments but depreciation and amortization can’t be postponed indefinitely, even though they’re non-cash expenses. Equipment does wear out and funds will be needed to replace it.
Lastly, but by no means least, EBITDA can make a company look less expensive than it actually is. When analysts look at stock price multiples of EBITDA instead of bottom-line earnings, lower multiples are produced. Investors need to look at other price multiples besides EBITDA when assessing a company’s value.
Figuring out whether an EBITDA number is “good” or not requires calculating a company’s EBITDA margin or EBITDA coverage ratio.
EBITDA margin is a measure of a company’s operating profitability relative to its revenue. The EBITDA margin allows for a comparison of one company’s real performance to others in its industry.
The formula for the EBITDA margin is as follows:
EBITDA margin = EBITDA / Total Revenue
EBITDA divided by total revenue equals operating profitability, the EBITDA margin. A company with total revenue of $500,000 and EBITDA of $75,000 would have an EBITDA margin of 15% ($75,000/$500,000). If one company has a larger EBITDA margin than another, it’s likely that a buyer or investor will see more potential in the former.
EBITDA coverage ratio is a metric that shows if a company is profitable enough to cover its debts. It compares a company’s EBITDA to its liabilities (debt and lease payments).
The formula for the EBITDA coverage ratio is as follows:
(EBITDA + Lease Payments) / (Principal Payments + Interest Payments + Lease payments)
A ratio of 1 means the company will be able to meet debt obligations, but barely. The higher the ratio, the more cash and less debt a company has.
After you’ve determined your company’s EBITDA (or EBITDA margin), you’ll likely aim to increase this value. Especially if you’re planning to place your company on the market. Here are some ways to give your EBITDA a boost:
A discretionary expense is a cost that a company can get by without, if necessary. For example, a company may allow employees to charge the cost of gym memberships to the company. This is done in order to promote goodwill with employees, rather than to ensure the company’s survival.
The best way to improve your company’s EBITDA is to review and manage expenses. Be more strict about non-essential expenses. Review your current suppliers and service providers and assess whether you can eliminate the service or reduce the cost.
For most companies, staffing is by far the largest expense and can account for up to 70% of total business expenses. Staffing costs include wages, benefits, and training. One way to improve EBITDA is to reduce these costs by employing such tactics as adding freelancers or contract labor to your workforce. Take advantage of technology and use payroll software to handle functions once requiring full-time HR personnel.
You may have been offered a “can’t-pass-up” deal and bought more inventory than you could sell. Unfortunately, the unsold merchandise sat in your warehouse and became an operational expense that negatively impacted your EBITDA. Revamp your inventory management system to keep unsold merchandise to a minimum.
Just as trimming expenses is a way to improve EBITDA, boosting your earnings is another. If your product mix is mostly comprised of low-ticket items, add products with higher margins.
If EBITDA critics feel it’s a questionable measure of profitability, what other metrics can investors fall back on? According to the “Oracle of Omaha”, the answer is Owner Earnings. Owner earnings is a valuation method detailed by Warren Buffett in Berkshire Hathaway‘s 1986 annual report. He stated that the value of a company is simply the total of the net cash flows (owner earnings) expected to occur over the life of the business, minus any reinvestment of earnings.
The formula for Owner Earnings:
Reported Earnings
plus
Depreciation, depletion, amortization, and other non-cash charges
less
Average annual amount of capital expenditures for plant and equipment for business to maintain its long-term competitive position and unit volume
Just as the EBITDA margin measures a company’s operating profitability, there are other margin ratios (also called profitability ratios) that will let you know if your company is profitable. To calculate the ratios, you’ll first need to obtain the following three figures from the income statement:
If your company sells physical products, gross profit margin allows you to hone in on product profitability. The formula to calculate the gross profit margin is:
Gross Profit Margin Ratio = (Gross Profit ÷ Sales) × 100
If the gross profit margin is high, it means you’re keeping a lot of profit relative to what you’re paying for products. This margin should remain pretty stable.
The operating profit margin gives you a view of your current earning power and efficiency. It shows your ability to turn sales into pre-tax profits. Unlike the gross profit margin, which you would prefer to be stable, an increase in the operating profit margin is indicative of a healthy company. The formula to calculate the operating profit margin is:
Operating Profit Margin Ratio = (Operating Income ÷ Sales) × 100
One of the things that can cause this ratio to be stagnant is an increase in operating expenses. If you suspect that some operating costs are rising, perform a comparative analysis of operating expenses.
Net profit margin, often referred to as simply “profit margin”, gives an overview of a company’s profitability.
Use industry standards as a benchmark, and perform a year-over-year comparison to assess performance. The formula to calculate the net profit margin ratio is:
Net Profit Margin Ratio = (Net Income ÷ Sales) × 100
Net profit margin is similar to operating profit margin, except it accounts for earnings after taxes.
ROI shows how much you’re earning relative to how much you’re investing. Your ROI should be at least as high as what you’d earn in a risk-free investment, like a high-yield savings account or CD. If not, you’re wasting your time and money. The formula to calculate ROI is:
Return on Investment = Net Profit Before Tax ÷ Net Worth
EBITDA is a widely-used method of analyzing and comparing profitability among companies and industries as it eliminates the effects of financing and accounting decisions. Investors and analysts would be wise to use multiple profitability metrics when analyzing the financial performance of a company since EBITDA does have some limitations.
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