EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortisation, is simply the measure of a company’s operating profitability. It is an indicator of the business’s real value that cannot be manipulated by accounting strategies. How so? Let’s see.
EBITDA is a measurement of a company’s financial performance before external factors impact its profitability, like taxes and interest. Sometimes it is used in place of net income as a good alternative. Although companies don’t need to report EBITDA, it’s a good estimation of a company’s operational viability as it determines net cash-flow.
EBITDA isn’t foolproof. It has limitations. But before discussing the details, let’s get a fair understanding of the concept.
EBITDA determines a company’s earnings while excluding the non-operating expenses that the company has no control over, like the interest expenses or debt finances, taxes, depreciation, among others. This also, then, becomes a good measure to compare the viability and attractiveness of the companies that are of different sizes in the industry, for investors. EBITDA, in other words, represents the company’s cash flow. EBITDA is a variant of operating income or EBIT (Earnings Before Interest and Taxes).
In understanding the exclusions, we will better understand how EBITDA only looks at variables related to operations.
- Interest is the expenses a business incurs due to changes in interest rates, loan repayments, among others.
- Taxes include taxes paid to the state, centre, direct and indirect taxes.
- Depreciation is the non-cash expense incurred on maintenance and wear and tear of assets.
- Amortisation is the cost of intangible assets spread over the life of the asset, which can be predetermined. These assets could include copyrights, patents, agreements, contracts and organisational costs.
LTM or Last Twelve Months EBITDA is more precise as it gives you the earnings before interest, taxes, and depreciation over the last 12 months. This gives analysts a clear picture of the company’s operations currently.
EBITDA is quite easy to calculate – one of the pluses of using EBITDA to measure profitability. Analyst calculates EBITDA from available financial statements of the company even when it is not exclusively reported.
Information on earnings, tax, and interest is reported in the company’s income statement as a norm, and deductions related to depreciation and amortizations are mentioned in the cash outflow statement. Analysts use both to derive ETIBDA.
A simple way to calculate EBITDA is to take the company’s operating profit, called earnings before interest and tax, and then add depreciation and amortization values. It is a shortcut approach but works just as fine.
There are two very simple formulae to calculate EBITDA. First is the long and detailed formula and the second one if the shortcut.
EBITDA= Net profit+Interest+Tax+Depreciation+Amortization
EBITDA= Operating Income+Depreciation+Amortization
What is EBITDA Margin?
How do you know if the EBIDTA of a company is good enough? (People also use EBIT or EBITA as a replacement for EBITDA. EBIT is earnings before interest and taxes or operating margins. EBITA is earnings before interest, taxes and amortisation).
You need to look at a company’s EBITDA margins for that. EBITDA Margins can be determined by dividing the total EBITDA by the total revenue of the company. EBITDA margins are indicative of a company’s profitability ratio. It measures EBITDA as a percentage of revenue. It is then used to measure the company’s performance against industry performance metrics.
What do EBITDA margins indicate about the company?
Higher EBITDA margins show robust growth opportunity for investors as high EBITDA margins indicate lower operating expense concerning overall revenues.
Let us see an example,
Firm ABC has total revenues worth Rs. 1.5 crore. It has an EBITDA of 15 lakh. Company’s EBITDA margin stands at 10%.
Now, suppose company XYZ has an EBITDA margin of 8%, this would mean that between company ABC and XYZ, all other factors remaining constant, ABC has higher operating profitability ratio and lower operating expenses. Higher EBITDA margin or EBIT margins also show flexibility in cutting costs by a company.
Difference Between EBITDA and Adjusted EBITDA
What adjusted EBITDA does is, it simply standardises the cash flow and income and does away with anomalies, so analysts can better compare the EBITDA of two companies.
In calculating the adjusted EBITDA, we remove one time, infrequent and non-recurring costs that may not have a direct impact on a company’s day to day operations. These include
- Unrealised one-time gains or losses
- Non-cash expenses
- Compensation in the form of shares
- Write-down of assets,
- Foreign exchange gains/losses, among others
EBITDA Multiple: Meaning and Importance
The EBITDA Multiple depends on another factor called Enterprise Value which is the sum of market cap, debt on the books, minority stake, and preferred shares, minus cash.
EBITDA Multiple is derived by dividing the Enterprise Value by the EBITDA.
EBITDA Multiple=Enterprise Value/EBITDA
Importance of the EBITDA Multiple Ratio
The EBITDA Multiple ratio signals if a company is overvalued or undervalued. The multiple takes into account a company’s debt, which makes it even clearer for buyers and analysts, along with EBITDA, to see how the company will do with given debt on its books. A high EBITDA multiple ratio shows the company may be overvalued since the EBITDA is relatively low. A low EBITDA multiple ratio shows the company may be relatively undervalued.
Importance of EBITDA
Here’s why you need EBITDA for most accurate valuation of a company’s business.
- Gives you a clear idea of the company’s real value
Comparing companies is easier; EBITDA removes the impact of elements like capital financing, capital depreciation or taxes.
- Demonstrative value
EBITDA is the focus for valuation analysts, investment bankers or private equity investors. That’s because while buying or valuing a business, it is important to know how capable a company is to generate cash flows to sustain itself and if it can provide good returns to its shareholders.
- Value of EBITDA margins
Also, the increase in EBITDA margins is directly proportional to an increase in the value of a company. It is the simplest ratio to prove a firm’s business value in terms of operating costs relative to total revenues.
EBITDA: Pros And Cons
There are a lot of reasons why EBITDA is the choice of measure for serious analysts and interested buyers in judging the valuation of a company.
Benefits of EBITDA
1. It provides a clear view of a business’s operational profitability.
2. To demonstrate a firm’s operating performance, it eliminates non-applicable expenses from the picture, including capital structure, interest payments and expenses covering depreciation and amortisation of intangible assets.
3. In other words, it gives a more immediate picture of how a company is operating its business on a day to day basis.
4. It is a neat view of a company’s cash flows generated during ongoing business
5. It reflects the capacity of a company to generate profits first.
6. It has a comparative value and enables you to compare two companies efficiently on how well their operations are doing.
7. The formula to calculate EBIDTA of a company is as straight forward as it gets and easiest to arrive at a company’s baseline profits.
Drawbacks of EBITDA
1. It focuses on baseline profits, but it has often drawn criticism for failing to include capital expenditure. It excludes problems in a capital structure like it discounts changes in working capital.
2. EBITDA does not fall under GAAP or General Accepted Accounting Principles, which opens it to the possibility of interpreting EBITDA and its components in multiple ways. This may leave room for manipulations that investors may only come to know of at a later point.
3. EBITDA assumes depreciation or amortisation costs can be taken care of at a later point. Still, for specific industries like manufacturing, this could be a significant expense that may need to be looked into.
4. Liquidity, required to keep operations running, can be influenced by tax outgo, interest payments or capital expenditures.
5. Changes in tax laws and tax implications can also have a bearing on certain businesses.
6. EBITDA does not say if a company is overleveraged, which can raise questions about a company’s repayment abilities.
7. EBITDA will not tell you if there have been changes made to schedules for writing down depreciation, which can later backfire.
8. EBITDA also does not consider how easy or difficult is the process of liquidation of assets.
Use of EBITDA
EBITDA came into prominence in the mid-80s when analysts started to use it as leverage buyout to measure a company’s debt repayment abilities. They used it as a tool to evaluate a distressed firm on parameters of its ability to meet heavier debt repayment in the near-term. To do it, they would look at the EBITDA-to-interest coverage ratio. For example, a company with an EBITDA of Rs 5 lakh can meet its interest charges of Rs 2.5 lakhs for two years.
EBITDA offers a clearer picture. It neutralises the effects of external factors that can obscure the actual operational performance of a company. It is the net income with interest, tax, depreciation, and amortization factors added back to it.
Why Is EBITDA Important To Investors?
The reason we are discussing EBITDA in such details is that it is an important metric for investors. EBITDA comes in handy while picking the right stocks for investment – it gives an idea of the company’s operational efficiency and ability to meet debt requirements through the EBITDA-to-interest coverage ratio. It is more accurate compared to other available methods because EBITDA excludes the influence of the non-operational factors that the company has no control over. It provides a more holistic view of a company’s financial health, which is why investors and analysts prefer using it over other financial analysis measures.
EBITDA throws light on the following
– EBITDA is a measure of a company’s earnings before adjusting it for non-operational factors
– EBITDA margin reflects the company’s short-term operational efficiency as a percentage of revenue
– The value is particularly useful for comparing companies with different capital investment, debt, and tax requirements
– Investors must be wary of company’s that rely too heavily on EBITDA because it sometimes can obscure the actual financial abilities of the company
In short, before buying into a company or valuing a company, you need experts and analysts to be able to read the health of a business by calculating key operational ratios like EBITDA, EBITDA multiple, and adjusted EBITDA. It offers a simple but accurate view of a company’s efficiency in generating an operational profit and managing hefty interest charges in a short duration. But while EBITDA is useful, investors are also warned not to rely heavily on it. It can be misleading at times, and companies that don’t have strong profitability to project use EBITDA to guise their actual financial performance.