By taking these out of the equation, EBITDA gives investors a good idea of how a company is doing financially and paints a portrait of how much cash a young or restructured company may generate before paying its debts. Using EBITDA as a metric also means it shows higher profits rather than simply providing operating profits. This is especially important for companies that are more focused on capital such as cable and telecoms.
A retail company generates $100 million in revenue and incurs $40 million in product cost and $20 million in operating expenses. Depreciation and amortization expense amounts to $10 million, yielding an operating profit of $30 million. The interest expense is $5 million, leading to earnings before taxes of $25 million. With a 20 percent tax rate, net income equals $20 million after $5 million in taxes are subtracted from pre-tax income. Using the EBITDA formula, we add operating profit to depreciation and amortization expense to get EBITDA of $40 million ($30 million + $10 million).
It is a non-GAAP measure that allows for a greater amount of discretion in what is and what is not included in the calculation. This also means that companies often change the items included in their EBITDA calculation from one reporting period to the next.
EBITDA came into more common use with leveraged buyouts in the 1980s, when it was used to indicate the ability of a company to service debt. As time passed, EBITDA became popular in industries with expensive assets that had to be written down over long periods of time. EBITDA is now commonly quoted by many companies, especially in the tech sector.
A common misconception is that it represents cash earnings. It is a good metric to evaluate profitability but not cash flow. It also leaves out the cash required to fund working capital and the replacement of old equipment, which can be significant. Consequently, EBITDA can be used as an accounting gimmick to dress up a company’s earnings. When using this metric, it is key that investors also focus on other performance measures to make sure the company is not trying to hide something with EBITDA.
Although EBITDA is not a financial measure recognized in generally accepted accounting principles, it is widely used in many areas of finance when assessing the performance of a company, such as securities analysis. It is intended to allow a comparison of profitability between different companies, by discounting the effects of interest payments from different forms of financing (by ignoring interest payments), political jurisdictions (by ignoring tax), collections of assets (by ignoring depreciation of assets), and different takeover histories (by ignoring amortization often stemming from goodwill). EBITDA is a financial measurement of cash flow from operations that is widely used in mergers and acquisitions of small businesses and businesses in the middle market. It is not unusual for adjustments to be made to EBITDA to normalize the measurement allowing buyers to compare the performance of one business to another.
A negative EBITDA indicates that a business has fundamental problems with profitability and with cash flow. A positive EBITDA, on the other hand, does not necessarily mean that the business generates cash. This is because EBITDA ignores changes in working capital (usually needed when growing a business), in capital expenditures (needed to replace assets that have broken down), in taxes, and in interest.
Some analysts do not support omission of capital expenditures when evaluating the profitability of a company: capital expenditures are needed to maintain the asset base which in turn allows for profit. Warren Buffett famously asked, “Does management think the tooth fairy pays for capital expenditures?”
Over time, EBITDA has mostly been used as a calculation to describe the performance in its intrinsic nature, which means ignoring every cost that does not occur in the normal course of business. In spite of the fact this simplification can be quite useful, it is often misused, since it results in considering too many cost items as unique, and thus boosting profitability. Instead, in case these sort of unusual costs get downsized, the resulting calculation ought to be called “adjusted EBITDA” or similar.
Because it (and its variations) are not measures generally accepted under U.S. GAAP, the U.S. Securities and Exchange Commission requires that companies registering securities with it (and when filing its periodic reports) reconcile EBITDA to net income in order to avoid misleading investors.
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