What is EBITDA?
EBITDA is simply a acronym for the words “Earnings before interest, tax, depreciation, and amortization”. Simply put, is the measurement of company’s operating profitability. It excludes these non-operating expenses to give you a better picture of your company’s actual performance.
A Little More About EBITDA
Here is the formula.
EBITDA = Net Income + Interest (expense) + Depreciation + Amortization (all for the fiscal reporting period).
Let’s take a look at the key factors that make up EBITDA.
Earnings consist of revenue minus expenses. This leads us to the question of, “aren’t interest, taxes, depreciation and amortization all expenses?” The answer — yes, yes they is. There is a reason for separating out these expenses. We will explain as we address each one.
Interest expense is what a company pays on the debt that it owes (usually in the form of corporate bonds). Taking interest payments out of the net income calculation is the best way to neutralize how the cost of debt can skew earnings and its affect on taxes owed. If a company relies heavily on debt, such as when the company is fully leveraged as party of a leveraged buyout, it better reflects company performance to show the net earnings without the heavy interest expense.
Taxes are the expenses that a company owes to tax regulatory authorities such as the Internal Revenue Service (IRS) or state or local taxing authorities. Taxes are nothing if not readily altered by various tax planning techniques. The amount a company pays in taxes in a given year can easily distort the performance numbers. Also, taxes do not always raise the EBITDA number, as many companies do not report a profit for tax purposes. This is particularly true when a company has loss carry forwards or excessive debt (the interest payments offsets profitability).
Deprecation is the decrease in economic value of a physical asset that has a fixed useful life as determined by the IRS. Depreciation is taken on an asset that was previously purchased. It is an expense that generally does not match with the outlay of capital to acquire it. As such, depreciation expenses do not affect the actual cash on hand. Rather, it is an accounting measure to show a company’s asset is decreasing.
Amortization is the decrease in the value of intangible assets that have a fixed useful life. Amortization is only taken to the extent of the company’s basis in the intangible asset. This is normal research and development costs (R&D). Once the R&D cost is fully amortized when it has all been treated as an expense. Because the R&D payments were made at an earlier time, amortization does not affect available cash.
EBITDA is commonly used when comparing high-debt companies. When a company does not have very impressive net income, it looks better to filter out the effects of debt payments (interest) and the non-cash affects of depreciation of tangible assets and the amortization of intangible ones. It takes the sting out of an otherwise low profitability number.
Example of Calculating EBITDA
Example Let’s assume ABC Company EBT ($450,000), Interest Expense ($60,000), Depreciation ($85,000) and Amortization ($35,000) and then use the formula above:
EBITDA = $450,000 + $60,000 + $85,000 + $35,000 = $630,000
In the example, the we go ahead and taxes back to earnings.
References for EBITDA