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What Is EBITDA?
EBITDA, or earnings before interest, taxes, depreciation, and amortization, is an
alternate measure of profitability to net income. By stripping out the non-cash
depreciation and amortization expense as well as taxes and debt costs
dependent on the capital structure, EBITDA attempts to represent cash profit
generated by the company’s operations.
KEY TAKEAWAYS
Earnings before interest, taxes, depreciation, and amortization
(EBITDA) is a widely used measure of core corporate profitability.
EBITDA is calculated by adding interest, tax, depreciation, and
amortization expenses to net income.
EBITDA lets investors assess corporate profitability net of expenses
dependent on financing decisions, tax strategy, and discretionary
depreciation schedules.
Some, including Warren Buffett, call EBITDA meaningless because it
omits capital costs.
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The U.S. Securities and Exchange Commission (SEC) requires listed
companies to reconcile any EBITDA figures they report with net income
and bars them from reporting EBITDA per share.
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EBITDA
The earnings (net income), tax, and interest figures are found on the income
statement, while the depreciation and amortization figures are normally found
in the notes to operating profit or on the cash flow statement. The usual
shortcut for calculating EBITDA is to start with operating profit, also
called earnings before interest and taxes (EBIT), then add back depreciation
and amortization.
There are two distinct EBITDA formulas, one based on net income and the other
on operating income. The respective EBITDA formulas are:
and
Understanding EBITDA
EBITDA is net income (earnings) with interest, taxes, depreciation, and
amortization added back. EBITDA can be used to track and compare the
underlying profitability of companies regardless of their depreciation
assumptions or financing choices.
Annual changes in tax liabilities and assets that must be reflected on the
income statement may not relate to operational performance. Interest costs
depend on debt levels, interest rates, and management preferences regarding
debt vs. equity financing. Excluding all these items keeps the focus on the cash
profits generated by the company’s business.
Example of EBITDA
A company generates $100 million in revenue and incurs $40 million in cost of
goods sold and another $20 million in overhead. Depreciation and amortization
expenses total $10 million, yielding an operating profit of $30 million. Interest
expense is $5 million, leaving earnings before taxes of $25 million. With a
20% tax rate and interest expense tax deductible, net income equals $21 million
after $4 million in taxes is subtracted from pretax income. If depreciation,
amortization, interest, and taxes are added back to net income, EBITDA equals
$40 million.
Taxes +$4,000,000
EBITDA $40,000,000
History of EBITDA
EBITDA is the invention of one of the very few investors with a record rivaling
Buffett’s: Liberty Media Chair John Malone. [4] The cable industry pioneer came
up with the metric in the 1970s to help sell lenders and investors on his
leveraged growth strategy, which deployed debt and reinvested profits to
minimize taxes. [5] [6]
During the 1980s, the investors and lenders involved in leveraged buyouts
(LBOs) found EBITDA useful in estimating whether the targeted companies had
the profitability to service the debt likely to be incurred in the acquisition. Since
a buyout would likely entail a change in the capital structure and tax liabilities,
it made sense to exclude the interest and tax expense from earnings. As non-
cash costs, depreciation and amortization expense would not affect the
company’s ability to service that debt, at least in the near term. [7]
The LBO buyers tended to target companies with minimal or modest near-term
capital spending plans, while their own need to secure financing for the
acquisitions led them to focus on the EBITDA-to-interest coverage ratio, which
weighs core operating profitability as represented by EBITDA against debt
service costs. [7]
EBITDA gained notoriety during the dotcom bubble, when some companies
used it to exaggerate their financial performance. [8]
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The metric received more bad publicity in 2018 after WeWork Companies Inc., a
provider of shared office space, filed a prospectus for its initial public offering
(IPO) defining its “Community Adjusted EBITDA” as excluding general and
administrative as well as sales and marketing expenses. [9] [10]
Drawbacks of EBITDA
Because EBITDA is a non-GAAP measure, the way it is calculated can vary from
one company to the next. It is not uncommon for companies to emphasize
EBITDA over net income because the former makes them look better.
An important red flag for investors is when a company that hasn’t reported
EBITDA in the past starts to feature it prominently in results. This can happen
when companies have borrowed heavily or are experiencing rising capital and
development costs. In those cases, EBITDA may serve to distract investors from
the company’s challenges.
“There’s been some real sloppiness in accounting, and this move toward using
adjusted EBITDA and adjusted earnings has produced some companies that I
think are trading on valuations that are not supported by the real
numbers,” hedge fund manager Daniel Loeb said in 2015. [12]
Not much has changed on that front since then. Investors using solely EBITDA
to assess a company’s value or results risk getting the wrong answer.
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analyze the profitability of a company’s core operations. The following formula
is used to calculate EBIT:
Since net income includes interest and tax expenses, to calculate EBIT, these
deductions from net income must be reversed. EBIT is often mistaken for
operating income since both exclude tax and interest costs. However, EBIT may
include nonoperating income while operating income does not.
Earnings before tax (EBT) reflects how much of an operating profit has been
realized before accounting for taxes, while EBIT excludes both taxes and
interest payments. EBT is calculated by adding tax expense to the company’s
net income.
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patents or trademarks as well as goodwill, the difference between the cost of
past acquisitions and their fair market value when purchased.
The Bottom Line
EBITDA is a useful tool for comparing companies subject to disparate tax
treatments and capital costs, or analyzing them in situations where these are
likely to change. It also omits non-cash depreciation costs that may not
accurately represent future capital spending requirements. At the same time,
excluding some costs while including others has opened the door to the
metric’s abuse by unscrupulous corporate managers. The best defense against
such practices is to read the fine print reconciling the reported EBITDA to net
income.
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Related Terms
EDITDAR: Meaning, Formula & Calculations, Example,
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EBITDAR—an acronym for earnings before interest, taxes, depreciation, amortization, and
restructuring or rent costs—is a non-GAAP measure of a company's financial
performance. more
Operating Income
Operating income is a company's profit after deducting operating expenses such as
wages, depreciation, and cost of goods sold. more
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