Earnings Before Interest, Taxes, Depreciation and Amortization, or EBITDA, is a shorthand metric for measuring the economic success of a company. By excluding variable expenses like interest and depreciation, the calculation provides a look at a company’s profitability in the eyes of investors who may be seeking a leveraged buyout of the firm. While EBITDA is relied upon by many investors to make quick judgements on the viability of a purchase, it’s important to note that there remain more comprehensive measurements of a firm’s financial performance. 

H2: What is EBITDA?

The process for determining a company’s EBITDA is relatively straightforward. By starting with a firm’s net income over the last period, and adding back expenses such as depreciation, interest, and taxes, investors are able to determine whether the company can survive through corporate restructuring or merger. Investors seeking buyouts of struggling companies typically weigh the EBITDA calculation against an estimate of the additional interest expenses that arise as a result of restructuring; if the EBITDA outweighs the potential interest payments, it’s understood that the company is financially viable for purchase. 

Though EBITDA provides a quick glimpse into the performance of a company, it is not a comprehensive metric for financial success. EBITDA offers a “best-case” view of a company’s finances, assuming that expenses such as taxes and depreciation will be repaid through growth or will cease to be an issue. Certain expenses like interest payments to lenders or equipment refinancing, which in reality impact a company’s viability, are left out of the picture of a business’s strength. Because of these drawbacks, EBITDA remains a shorthand measure of profitability rather than a standard metric for strength. Unlike Net and Gross income, EBITDA is not required to be reported by firms, and is usually determined by extracting various data from other publicly available sources.

EBITDA Formula and Calculation

Open this section by explaining that the EBITDA formula provides a rather simple calculation for EBITDA. Explain that this information can be found in a company’s financial records (balance sheet).

Though a company’s EBITDA is not publicly available or universally accepted, there is a simple formula for determining a firm’s profitability just based on the information available in their balance sheet and other financial records. 

H3: EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization

A company’s EBITDA is calculated through the simple addition of various parts of their financial records. Each of the components of the EBITDA formula, listed above, can be found in publicly available statements related to company performance. The first three pieces of EBITDA, Net Income and Interest and Tax obligations, can be found on a company’s income statement. For information on the costs of depreciation and amortization, or the loss of physical capital due to wear and tear, examine a company’s cash flow statement. 

In certain cases, readily available information on a business allows investors to calculate EBITDA with the even shorter equation: 

EBITDA = Operating Profit + Depreciation Expense + Amortization Expense. 

Benefits of EBITDA

The benefits of using EBITDA as a metric of financial performance are most prominent for companies that face negative balance sheets due to large amounts of debt or physical assets. By using EBITDA rather than net income, companies can showcase their value to investors without having their evaluation saddled down by negative figures. Generally speaking, investors trust EBITDA as a metric for profitability because many of the factors included in the equation, such as capital interest payments and corporate taxes, will be less of an issue after company restructuring or a leveraged buyout. 

For companies with a lower net income, perhaps because of interest payments to lenders or annual tax payments, EBITDA is a highly favorable method of determining financial performance. By removing these extraneous variables from their valuation, business owners hope to showcase only the upside of their business to potential investors. 

Drawbacks of EBITDA

Though many companies use EBITDA to measure their performance, there are a number of drawbacks to the calculation that prevent it from being considered a part of the Generally Acceptable Accounting Procedures (GAAP) for determining financial health. 

For example, even though many take EBITDA as a measure of a company’s earnings, the fact that equipment and tax costs are excluded from the calculation means that the figure gives an incomplete picture of the situation. Though daily operations and sales are typically the most important determinants of a company’s profits, other costs related to physical assets and tax payments can seriously affect the balance sheet of a company. Consider a clothing company that has not implemented new equipment in many years; their EBITDA would reflect only their sales in recent months, leaving out of the equation potentially massive future expenses related to replacing physical assets. 

Perhaps the biggest issue with EBITDA is that it claims to provide insight into a company’s profitability without giving any information about the cash flow and working capital of a business. These two factors determine the day-to-day viability of a business model. The EBITDA calculation, however, is concerned only with the large-scale balance sheet of a business. It’s highly possible that a company could present a favorable EBITDA while being saddled with daily capital shortages and cash flow problems. In that case, the EBITDA calculation obscures true financial health, and gives an insincere look into the profits of a company. 

Though there are many acceptable reasons to rely on EBITDA as a metric for financial reporting, common wisdom says that if a firm makes a sudden shift to reporting only EBITDA, or if they tend to emphasize EBITDA over other metrics of success, investors ought to proceed with caution. 

Example of EBITDA Calculation

Below, we’ve completed a sample calculation of a company’s EBITDA. 

Consider a company whose net income over the last period was $60 million, with depreciation costs of $30 million, net interest payments of $8 million, and an additional $2 million paid in taxes. 

The net income figure already includes subtractions for the extraneous costs listed above, so to arrive at this firm’s EBITDA, we simply add back each part of the equation.

Recall the formula: 

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

Applied in the case of this fictional business, we calculate: 

EBITDA = $60 million + $30 million + $8 million + $2 million = $100 million

As you can see, the EBITDA of this firm obscures a far lower net income and hides costs related to equipment and interest payments. Clearly, the EBITDA formula has its benefits for companies struggling to maintain positive balance sheets. 

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Author:

Jeffrey Bumbales
Director, Marketing & Strategic Partnerships at Credibly

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