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
Academic Research on EBITDA
- ● EBITDA!, Grant, J., & Parker, L. (2002). Research in Accounting Regulation, 15, 205-212. This paper highlights different definitions and explanations of a popular non-GAAP alternative performance method, EBITDA. The main aim of the authors is to provide consideration and review of various instances where this measure has been applied.
- ● EBITDA: an overrated tool for cash flow analysis, Eastman, K. (1996). Com. Lending Rev., 12, 64. EBITDA is the most used system for cash flow analysis by credit lenders and bankers due to its simplicity. This article however focuses on the different shortcomings of this system.
- ● EBITDA: still crucial to credit analysis, Hamilton, B. (2003). Com. Lending Rev., 18, 47. This article explores the use of EBITDA by different managers in calculating cash flow analysis and cost. The author aims to show that the use of EBITDA might not add value to a business, as most of the tasks carried out by this system can be completed relatively quick by human knowledge. It also aims to show the different analysis which cannot be covered by EBITDA, with a typical example being goods bought on credit.
- ● Earnings, accruals, cash flows, and EBITDA for agribusiness firms, Omar Trejo-Pech, C., Weldon, R. N., & House, L. A. (2008). Agricultural Finance Review, 68(2), 301-319. This research studies the relationship between earnings, accruals and cash flow, for the US food supply and compares them to that of the US market. It also analyses EBITDA as a proxy for cash flow. Different results and conclusions were brought up. The aim of this paper is to show that EBITDA is not a valid proxy for studying accruals..
- ● Ebitda/Ebit and cash flow based ICRs: a comparative approach in the agro-food system in Italy, Iotti, M., & Bonazzi, G. (2012)., calculations and processes of interest coverage ratios (ICRs). This article aims to shows the differences between using ICR based on EBITDA and EBIT solutions and ICRs based on various CF definitions.
- ● Managing M&A Risk with Collars, Earn‐outs, and CVRs, Caselli, S., Gatti, S., & Visconti, M. (2006). Journal of Applied Corporate Finance, 18(4), 91-104. This paper investigates the risks associated with M&A transactions. This article describes a number of tools that can be used to manage such risks, using a number of examples to illustrate the structure and pricing of such tools.
- ● To purchase or to pool: does it matter?, Lindenberg, E., & Ross, M. P. (1999). Journal of Applied Corporate Finance, 12(2), 32-47. This paper compares the difference between purchase and pooling, with regards to the safety of acquirers. This research shows that changes in accounting for acquisitions shouldn’t be a major concern for acquirers as the elimination of pooling wouldn’t have a lasting impact on corporate strategies.
- ● Accruals, Free Cash Flow and EBITDA for Agribusiness Firms, Trejo-Pech, C. O., Weldon, R., House, L., & Salas-Gutiérrez, T. (2006, July). In Proceedings of the American Agricultural Economics Association Annual Meeting (pp. 23-26). This study explores the relationships between the accrual and cash flow components of earnings for agribusiness. The main objective is to show the differences between the magnitude and behaviour of EBITDA and cash flow, and propose its discontinued use as a proxy.
- ● Beyond earnings: do EBITDA reporting and governance matter for market participants?, Cormier, D., Demaria, S., & Magnan, M. (2017). Managerial Finance, 43(2), 193-211. The purpose of this paper is to investigate whether formally disclosing an earnings before interests, taxes, depreciation, and amortization (EBITDA) number reduces the information asymmetry between managers and investors beyond the release of GAAP earnings. The paper also assess if EBITDA disclosure enhances the value relevance and the predictive ability of earnings.
- ● Dividend policy and firm performance: Hotel REITs vs. non-REIT hotel companies, Mooradian, R., & Yang, S. (2001). Journal of Real Estate Portfolio Management, 7(1), 79-87. This study investigates the impact of dependence on external equity financing on REITS and non-REITs hotels. This paper uses data from sixteen REITs and fifty-one- non-REITs hotels from 1993 -1999 as case study.
- ● Cash Flow at Risk Models: Principles, Application and a Case Study, LECOCQ, D. (2003). In 2003 Biennial Convention Shaping the Future: In a World of Uncertainty. This study explores the cash flow at different risk levels of a company. It analyses market risk, business modelling, analysis, and stress tests.