EBITDA – Earnings Before Interest, Taxes, Depreciation, and

Amortization
By ADAM HAYES
Updated Feb 4, 2021
What Is Earnings Before Interest, Taxes, Depreciation, and Amortization –
EBITDA?
EBITDA, or earnings before interest, taxes, depreciation, and amortization, is a
measure of a company's overall financial performance and is used as an alternative
to net income in some circumstances. EBITDA, however, can be misleading because it
strips out the cost of capital investments like property, plant, and equipment.

This metric also excludes expenses associated with debt by adding back interest
expense and taxes to earnings. Nonetheless, it is a more precise measure of corporate
performance since it is able to show earnings before the influence of accounting and
financial deductions.

Simply put, EBITDA is a measure of profitability. While there is no legal requirement for
companies to disclose their EBITDA, according to the U.S. generally accepted
accounting principles (GAAP), it can be worked out and reported using the information
found in a company's financial statements.

The earnings, tax, and interest figures are found on the income statement, while the
depreciation and amortization figures are normally found in the notes to operating profit
or on the cash flow statement. The usual shortcut to calculate EBITDA is to start with
operating profit, also called earnings before interest and tax (EBIT) and then add back
depreciation and amortization.

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EBITDA

EBITDA Formula and Calculation

EBITDA is calculated in a straightforward manner, with information that is easily found

on a company's income statement and balance sheet.

EBITDA = Net Income + Interest + Taxes + D + A

 Where:
D = Depreciation
A= Amortization

EBITDA = Operating Profit + DE + AE

Where:
DE = Depreciation Expense
AE = Amortization Expense

EBITDA and Leveraged Buyouts

EBITDA first came to prominence in the mid-1980s as leveraged buyout investors

examined distressed companies that needed financial restructuring. They used EBITDA
to calculate quickly whether these companies could pay back the interest on these
financed deals.

Leveraged buyout bankers promoted EBITDA as a tool to determine whether a

company could service its debt in the near term, say over a year or two. Looking at the
company's EBITDA-to-interest coverage ratio (in theory, at least) would give investors a
sense of whether a company could meet the heavier interest payments it would face
after restructuring. For instance, bankers might argue that a company with EBITDA of
$5 million and interest charges of $2.5 million had interest coverage of two – more than
enough to pay off debt.

EBITDA was a popular metric in the 1980s to measure a company's ability to service
the debt used in a leveraged buyout (LBO). Using a limited measure of profits before a
company has become fully leveraged in an LBO is appropriate. EBITDA was
popularized further during the "dot com" bubble when companies had very expensive
assets and debt loads that were obscuring what analysts and managers felt were
legitimate growth numbers.

Using EBITDA
The use of EBITDA has since spread to a wide range of businesses. Its proponents
argue that EBITDA offers a clearer reflection of operations by stripping out expenses
that can obscure how the company is really performing.

EBITDA is essentially net income (or earnings) with interest, taxes, depreciation,

and amortization added back. EBITDA can be used to analyze and compare profitability
among companies and industries, as it eliminates the effects of financing and capital
expenditures. EBITDA is often used in valuation ratios and can be compared
to enterprise value and revenue.

Interest expenses and (to a lesser extent) interest income are added back to net
income, which neutralizes the cost of debt, as well as the effect interest payments, have
on taxes. Income taxes are also added back to net income, which does not always
increase EBITDA if the company has a net loss. Companies tend to spotlight their
EBITDA performance when they do not have very impressive (or even positive) net
income. It's not always a telltale sign of malicious market trickery, but it can sometimes
be used to distract investors from the lack of real profitability.

Companies use depreciation and amortization accounts to expense the cost of property,
plants, and equipment, or capital investments. Amortization is often used to expense the
cost of software development or other intellectual property. This is one of the reasons
that early-stage technology and research companies feature EBITDA when
communicating with investors and analysts.

Management teams will argue that using EBITDA gives a better picture of profit growth
trends when the expense accounts associated with capital are excluded. While there is
nothing necessarily misleading about using EBITDA as a growth metric, it can
sometimes overshadow a company's actual financial performance and risks.

The Drawbacks of EBITDA

EBITDA does not fall under generally accepted accounting principles (GAAP) as a
measure of financial performance. Because EBITDA is a "non-GAAP" measure, its
calculation can vary from one company to the next. It is not uncommon for companies to
emphasize EBITDA over net income because it is more flexible and can distract from
other problem areas in the financial statements.

An important red flag for investors to watch is when a company starts to report EBITDA
prominently when it hasn't done so in the past. This can happen when companies have
borrowed heavily or are experiencing rising capital and development costs. In this
circumstance, EBITDA can serve as a distraction for investors and may be misleading.

Ignores Costs of Assets

A common misconception is that EBITDA represents cash earnings. However,
unlike free cash flow, EBITDA ignores the cost of assets. One of the most common
criticisms of EBITDA is that it assumes that profitability is a function of sales and
operations alone – almost as if the assets and financing the company needs to survive
were a gift.

Ignores Working Capital

EBITDA also leaves out the cash required to fund working capital and the replacement
of old equipment. For example, a company may be able to sell a product for a profit, but
what did it use to acquire the inventory needed to fill its sales channels? In the case of a
software company, EBITDA does not recognize the expense of developing the current
software versions or upcoming products.

Varying Starting Points

While subtracting interest payments, tax charges, depreciation, and amortization from
earnings may seem simple enough, different companies use different earnings figures
as the starting point for EBITDA. In other words, EBITDA is susceptible to the earnings
accounting games found on the income statement. Even if we account for the
distortions that result from interest, taxation, depreciation, and amortization, the
earnings figure in EBITDA is still unreliable.

Obscures Company Valuation

Worst of all, EBITDA can make a company look less expensive than it really is. When
analysts look at stock price multiples of EBITDA rather than bottom-line earnings, they
produce lower multiples.

Consider the historical example of wireless telecom operator Sprint Nextel. April 1,
2006, the stock was trading at 7.3 times its forecast EBITDA. That might sound like a
low multiple, but it doesn't mean the company is a bargain. As a multiple of forecast
operating profits, Sprint Nextel traded at a much higher 20 times. The company traded
at 48 times its estimated net income. Investors need to consider other price multiples
besides EBITDA when assessing a company's value.

Limitations of EBITDA
Earnings before interest, taxes, depreciation, and amortization (EBITDA) adds
depreciation and amortization expenses back into a company's operating profit.
Analysts usually rely on EBITDA to evaluate a company's ability to generate profits from
sales alone and to make comparisons across similar companies with different capital
structures. EBITDA is a non-GAAP measure and can sometimes be used intentionally
to obscure the real profit performance of a company.

Because of these issues, EBITDA is featured more prominently by developmental-

stage companies or those with heavy debt loads and expensive assets.

The measurement's sometimes bad reputation is mostly a result of overexposure and

improper use. Just as a shovel is effective for digging holes, it wouldn't be the best tool
for tightening screws or inflating tires. Thus, EBITDA shouldn't be used as a one-size-
fits-all, stand-alone tool for evaluating corporate profitability. This is a particularly valid
point when one considers that EBITDA calculations do not conform to generally
accepted accounting principles (GAAP).
Like any other measure, EBITDA is only a single indicator. To develop a full picture of
the health of any given firm, a multitude of measures must be taken into consideration.
If identifying great companies was as simple a checking a single number, everybody
would be checking that number, and professional analysts would cease to exist.

EBITDA vs. EBT and EBIT

EBIT (earnings before interest and taxes) is a company's net income before income tax
expense and interest expense have been deducted. EBIT is used to analyze the
performance of a company's core operations without tax expenses and the costs of the
capital structure influencing profit. The following formula is used to calculate EBIT: 

\textit{EBIT} = \text{Net Income} + \text{Interest Expense} + \text{Tax

Expense}EBIT=Net Income+Interest Expense+Tax Expense

Since net income includes the deductions of interest expense and tax expense, they
need to be added back into net income to calculate EBIT. EBIT is often referred to as
operating income since they both exclude taxes and interest expenses in their
calculations. However, there are times when operating income can differ from EBIT.

Earnings before tax (EBT) reflects how much of an operating profit has been realized
before accounting for taxes, while EBIT excludes both taxes and interest payments.
EBT is calculated by taking net income and adding taxes back in to calculate a
company's profit.

By removing tax liabilities, investors can use EBT to evaluate a firm's operating

performance after eliminating a variable outside of its control. In the United States, this
is most useful for comparing companies that might have different state taxes or federal
taxes. EBT and EBIT are similar to each other and are both variations of EBITDA.

Since depreciation is not captured in EBITDA, it can lead to profit distortions

for companies with a sizable amount of fixed assets and subsequently substantial
depreciation expenses. The larger the depreciation expense, the more it will boost
EBITDA.

EBITDA vs. Operating Cash Flow

Operating cash flow is a better measure of how much cash a company is generating
because it adds non-cash charges (depreciation and amortization) back to net income
and includes the changes in working capital that also use or provide cash (such as
changes in receivables, payables, and inventories).

These working capital factors are the key to determining how much cash a company is
generating. If investors do not include changes in working capital in their analysis
and rely solely on EBITDA, they will miss clues that indicate whether a company is
struggling with cash flow because it's not collecting on its receivables.

Example of Using EBITDA

A retail company generates $100 million in revenue and incurs $40 million in production
cost and $20 million in operating expenses. Depreciation and amortization expenses
total $10 million, yielding an operating profit of $30 million. Interest expense is $5
million, which equals earnings before taxes of $25 million. With a 20% tax rate, net
income equals $20 million after $5 million in taxes are subtracted from pre-tax income. If
depreciation, amortization, interest, and taxes are added back to net income, EBITDA
equals $40 million.

Net Income $20,000,000

Depreciation Amortization +$10,000,000
Interest Expense +$5,000,000
Taxes +$5,000,000
EBITDA $40,000,000

Many investors use EBITDA to make comparisons between companies with

different capital structures or tax jurisdictions. Assuming that two companies are both
profitable on an EBITDA basis, a comparison like this could help investors identify a
company that is growing more quickly from a product sales perspective.

For example, imagine two companies with different capital structures but a similar
business. Company A has a current EBITDA of $20,000,000 and Company B has
EBITDA of $17,500,000. An analyst is evaluating both firms to determine which has the
most attractive value.

From the information presented so far, it makes sense to assume that Company A
should be trading at a higher total value than Company B. However, once the
operational expenses of depreciation and amortization are added back in, along with
interest expense and taxes, the relationship between the two companies is more clear.

  Company A Company B
EBITDA $20,000,000 $17,500,000
Depreciation
-$2,000,000 $2,500,000
Amortization
Interest Expense -$8,000,000 -$5,000,000
 Taxes -$2,000,000 -$2,000,000
Net Income $8,000,000 $8,000,000

In this example, both companies have the same net income largely because Company
B has a smaller interest expense account. There are a few possible conclusions that
can help the analyst dig a little deeper into the true value of these two companies:

 Is it possible that Company B could borrow more and increase both EBITDA and
net income? If the company is underutilizing its ability to borrow, this could be a
source of potential growth and value.
 If both companies have the same amount of debt, perhaps Company A has a
lower credit rating and must pay a higher interest rate. This may indicate
additional risk compared to Company B and a lower value.
 Based on the amount of depreciation and amortization, Company B is generating
less EBITDA with more assets than Company A. This could indicate an inefficient
management team and a problem for Company B's valuation.

How Do You Calculate EBITDA?

You can calculate EBITDA using the information from a company's income statement,
cash flow statement, and balance sheet. The formula is as follows:

EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization

What Is a Good EBITDA?

EBITDA is a measure of a company's financial performance and profitability, so
relatively high EBITDA is clearly better than lower EBITDA. Companies of different sizes
in different sectors and industries vary widely in their financial performance. Therefore,
the best way to determine whether a company's EBITDA is "good" is to compare its
number with that of its peers—companies of similar size in the same industry and
sector.

What Is Amortization in EBITDA?

As it relates to EBITDA, amortization is an accounting technique used to periodically
lower the book value of intangible assets over a set period of time. Amortization is
reported on a company's financial statements. Examples of intangible assets include
intellectual property such as patents or trademarks, or goodwill derived from past
acquisitions.

Source:
Investopedia (Online) https://www.investopedia.com/terms/e/ebitda.asp