Building Blocks
By Blanche Zelmanovich and Coral M. Hansen
The Basics of EBITDA
E
arnings before interest, taxes, depreciation
and amortization (EBITDA) is a measure
commonly used to evaluate a company’s
profitability and the operational performance of
its core operations as compared to its competitors,
as it eliminates the effects of varying accounting
policies, as further discussed below. EBITDA is
frequently used in company valuation; the determi-
nation of a purchase price and loan covenant defini-
tions are often quoted as multiples of EBITDA.
All of the components used to calculate
EBITDA can be found on a company’s income
statement. However, unlike the financial terms on
a company’s income statement and other finan-
Blanche Zelmanovich cial statements, EBITDA is not a defined term
CBIZ Corporate under Generally Accepted Accounting Principles
Recovery Services (GAAP), guidelines that regulate the preparation
New York of financial statements. This means that the meth-
odology of calculating EBITDA can vary from
one company to another — or even within the
same company from period to period. On a high
level, some very basic adjustments to EBITDA
can include onetime occurrences for items such as
restructuring charges, which are common practice
in distressed situations, to costs associated with
non-recurring litigation expense.
EBITDA is also commonly used by many
Coral M. Hansen finance professionals as an estimate of a company’s
CBIZ Corporate ability to generate cash. While a negative EBITDA
Recovery Services
Los Angeles
generally indicates that a business has a profitabil-
ity issue and insufficient cash flow from its core
operations, a positive EBITDA does not necessarily
Blanche mean that a business will generate cash. EBITDA
Zelmanovich, CIRA is
can be a useful metric for some companies, given
a managing director
of CBIZ’s Corporate
that it strips away non-cash reductions to earnings.
Recovery Services For example, “fixed assets” (also known as tangi-
Practice in New ble assets or property, plant and equipment) is an
York. Coral Hansen, accounting term used for assets and property that
CPA, ABV, CFE, cannot easily be converted into cash. This can be
CFF is a managing compared with current assets such as cash or bank
director in the firm’s accounts, which are described as “liquid assets.”
Los Angeles office. The cost of purchasing a fixed asset is not recorded
as a reduction to earnings (i.e., placed on the income
statement) at the time of purchase. Rather, the ini-
tial cost is recorded on the balance sheet and later
allocated, as a depreciation expense, among peri-
ods in which the asset is expected to be used. To
further illustrate, if a company purchases a piece of
equipment for $100,000 and it is expected to last 10
years, a depreciation expense of $10,000 per year
for 10 years might be recognized, causing a reduc-
tion to earnings over time rather than in one lump
36 February 2017 ABI Journal
sum. Thus, manufacturing companies commonly
have large amounts of fixed assets and significant
depreciation charges, which are non-cash reductions
to earnings.
However, EBITDA is not synonymous with
cash flow. The “E” in EBITDA represents earnings,
not cash. EBITDA does not take into consideration
financing costs, investment in capital expenditures,
taxes and, in the cases of companies that grow
through acquisition, acquisition-related cash out-
lays such as the purchase of an additional business.
Analysts and buyers should not ignore these types
of costs, as the cash that is needed to finance these
obligations is necessary if the business wishes to
continue to operate and grow.
Further, EBITDA ignores changes in work-
ing capital, such as decreases or increases in
accounts receivable balances from prior periods,
which would indicate faster or slower conversion
of receivables to cash. Using the aforementioned
example, once the attorney finishes their case in
December, revenue is recorded on the income
statement and the amount owed by the client is
recorded as accounts receivable on the balance
sheet. Once the attorney collects the cash, their
client’s account receivable is reduced or removed.
Therefore, when the revenue was recorded in
December, EBITDA increased even though no
cash was received. When the client pays the bal-
ance due in a subsequent month, EBITDA is not
impacted, as EBITDA is calculated from the com-
pany’s income statement. As such, there are many
pitfalls that can come about by using EBITDA as
a proxy for cash from operations.
At a basic level, earnings in EBITDA are rev-
enues less expenses. Revenue recognition varies
across industries and does not always equate to
cash within the same time frame. For example, an
attorney may finish a huge case in December, but
may not collect the revenue earned for those ser-
vices until the following year. Those who work in
the professional services industry are all too aware
of this, which is a reason why most tax returns are
prepared using the cash method vs. the accrual
method of accounting. Under the accrual method
of accounting, the revenue earned in December will
increase December’s net income (earnings) and its
accounts receivable but will not increase, or change
at all, December’s cash flow, and therefore may not
be available to pay the current year’s income taxes,
as the collection of revenue would not likely occur
until the following calendar year.