What is EBITDA?
EBITDA — earnings before interest, taxes, depreciation, and amortization — is a measure of a company’s profitability. As the acronym suggests, EBITDA represents a company’s net earnings before subtracting expenses from interest payments, taxes, depreciation, and amortization. This accounting concept is a proxy for cash flow, or how much a company earns from operations and present assets.
EBITDA is a somewhat controversial accounting measure that is used as a rough approximation of a company’s cash flow. EBITDA allows financial analysts and investors to broadly compare the profit potential of different companies.
The measure erases the distortions that can creep into a company’s accounting statements from the effects of interest payments, tax impacts (and the political noise associated with taxes), the depreciation of assets, and different takeover histories by ignoring amortization of goodwill, leaving only total cash flow.
Businesses structure their capital differently from one another, so one company may have a high debt burden from acquisitions or equipment that another company doesn’t have. Different companies pursue a wide variety of tax strategies. Minimizing these factors aids in comparison. However, EBITDA is never meant as a way of looking at a company’s actual profitability or the quality of its earnings.
One argument against EBITDA as a performance indicator is that it does not account for changes in working capital, a key measure of a company’s liquidity. Working capital fluctuates due to the impact of interest, taxes, and capital expenditures.
EBITDA doesn’t need to be measured by the Securities and Exchange Commission’s accounting standards, the Generally Accepted Accounting Principles (GAAP), so it is not a required line item on a company’s financial statement. EBITDA has become much more common in recent years, although many firms list an adjusted EBITDA figure.
The measure can be calculated by taking a company’s net income and adding back interest expense, taxes, depreciation, and amortization. Alternatively, it can be calculated by taking a company’s operating profit — EBIT, or earnings before interest and taxes — and adding depreciation and amortization.
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Two partners are looking to buy another portfolio company for their investment firm. One target, CraftCo, generated $100 million in revenue in the prior financial year, with $40 million of product expense and $20 million of operating expenditures. Amortization and depreciation expenditure amounted to $10 million, making for a net profit from operations of $30 million.
CraftCo’s interest expense is $5 million, making $25 million in earnings before taxes. Assuming a tax rate of 20 percent, net income becomes $20 million after $5 million in tax expenditures. To arrive at EBITDA, the partners add operating profit to depreciation and amortization expenses ($30 million added to $10 million). CraftCo’s EBITDA of $40 million is higher than the other firm under consideration, so the partners enter negotiations to buy CraftCo.