EBITDA

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INTRODUCTION

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a financial metric
that measures a company's profitability by subtracting its operating expenses from its revenues.
Specifically, EBITDA is calculated by adding a company's earnings before interest, taxes,
depreciation, and amortization.

EBITDA analysis is the process of evaluating a company's financial performance using EBITDA
as a key metric. The analysis typically involves comparing a company's EBITDA to its
competitors or industry benchmarks to determine its relative performance.

EBITDA analysis can be useful in several ways. For example, it can help identify areas where a
company may be underperforming relative to its peers. Additionally, EBITDA analysis can be
used to evaluate the financial health of a company, particularly in industries with significant
capital expenditures.

However, it is important to note that EBITDA analysis has some limitations that should be
considered. One of the primary limitations is that EBITDA does not take into account a
company's interest and tax expenses, which can have a significant impact on its profitability.
Additionally, EBITDA does not consider changes in a company's working capital, which can
impact its ability to generate cash flow.

Therefore, it is recommended to use EBITDA analysis in conjunction with other financial


metrics to evaluate a company's financial performance. By using multiple metrics, analysts can
get a more comprehensive picture of a company's financial health and identify potential areas of
concern.

MEANING OF EBITDA

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a
financial metric that measures a company's profitability by subtracting its operating expenses
from its revenues. Specifically, EBITDA is calculated by adding a company's earnings before
interest, taxes, depreciation, and amortization.
Interest expense is the cost of borrowing money, and taxes are the amount of money a company
owes the government in income taxes. Depreciation and amortization are non-cash expenses that
reflect the decline in value of a company's assets over time.

EBITDA is often used by companies and investors to evaluate a company's financial


performance, as it provides a measure of a company's ability to generate cash flow from its
operations. However, it is important to note that EBITDA is not a GAAP (Generally Accepted
Accounting Principles) metric and as such, should be used in conjunction with other financial
metrics to evaluate a company's financial performance.

STRENGTHS AND WEAKNESSES OF EBITDA

EBITDA is a popular financial metric because it provides a measure of a company's ability to


generate cash flow from its operations. This makes it particularly useful in industries that require
significant capital expenditures, such as manufacturing or telecommunications. However,
EBITDA has some limitations that should be considered when using it as a financial metric.

Strengths:

Provides a better picture of a company's operational efficiency: EBITDA helps to isolate a


company's operational performance by removing the impact of non-operational expenses such as
interest, taxes, depreciation, and amortization, which can vary widely between companies and
can be affected by accounting policies.1

Useful for comparing companies across different industries: EBITDA is a widely used metric in
financial analysis as it allows for comparison of companies across different industries and
sectors, which may have different capital structures or tax rates.2

Helps in analyzing companies with high capital expenditures: EBITDA is a useful metric for
analyzing companies with high capital expenditures as it provides a measure of cash flow

1
Investopedia. (2021). Earnings Before Interest, Taxes, Depreciation, and Amortization - EBITDA. Retrieved from
https://www.investopedia.com/terms/e/ebitda.asp

2
Financial Times Lexicon. (n.d.). Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA).
Retrieved from https://lexicon.ft.com/Term?term=EBITDA
generated from operations, which can be used to evaluate a company's ability to fund its capital
expenditures.3

Weaknesses:

Does not reflect the impact of interest and taxes: EBITDA does not take into account a
company's interest and tax expenses, which can have a significant impact on a company's
profitability and cash flow.4

Can be manipulated by companies: EBITDA can be easily manipulated by companies through


their accounting policies, such as changes in depreciation and amortization rates. This can lead to
misleading results and distort a company's true financial performance.5

Does not reflect changes in working capital: EBITDA does not consider changes in a company's
working capital, which can impact a company's ability to generate cash flow. For example, a
company may have a high EBITDA but may have poor cash flow due to delays in collecting
receivables.6

Despite these weaknesses, EBITDA has several strengths that make it a useful financial metric.
For example, EBITDA is not affected by accounting choices or the depreciation schedules used
by a company. This can make it easier to compare the financial performance of different
companies, particularly in industries with significant fixed assets.

Pitfalls of Relying Solely on EBITDA

While EBITDA can be a useful financial metric, it is important not to rely solely on this measure
in financial analysis. Relying solely on can have the following pitfalls:
3
Harvard Business Review. (2016). A Refresher on EBITDA. Retrieved from https://hbr.org/2016/02/a-refresher-
on-ebitda

4
AccountingTools. (2022). EBITDA. Retrieved from https://www.accountingtools.com/articles/2017/5/5/ebitda

5
Wall Street Oasis. (n.d.). EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). Retrieved
from https://www.wallstreetoasis.com/finance-dictionary/ebitda

6
The Motley Fool. (2019). EBITDA vs. Free Cash Flow: Which Is More Important?. Retrieved from
https://www.fool.com/investing/2019/04/29/ebitda-vs-free-cash-flow-which-is-more-important.aspx
Fails to capture interest expenses: EBITDA does not take into account a company's interest
expenses, which can be significant for companies that carry a high amount of debt. Ignoring
these expenses can lead to an overestimation of a company's profitability and cash flow.7

Ignores tax implications: EBITDA does not account for tax expenses, which can have a
significant impact on a company's bottom line. This can result in a distorted view of a company's
true financial performance.8

Disregards depreciation and amortization: EBITDA does not reflect a company's depreciation
and amortization expenses, which can be significant for companies that rely heavily on fixed
assets. Ignoring these expenses can lead to an overestimation of a company's cash flow and
profitability.9

Does not consider changes in working capital: EBITDA does not take into account changes in a
company's working capital, which can impact a company's cash flow. For example, a company
may have a high EBITDA but may have poor cash flow due to delays in collecting receivables.10

Can be manipulated by companies: EBITDA can be easily manipulated by companies through


their accounting policies, such as changes in depreciation and amortization rates. This can lead to
misleading results and distort a company's true financial performance.11

CALCULATION OF EBITDA

7
Investopedia. (2021). Earnings Before Interest, Taxes, Depreciation, and Amortization - EBITDA. Retrieved from
https://www.investopedia.com/terms/e/ebitda.asp

8
Financial Times Lexicon. (n.d.). Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA).
Retrieved from https://lexicon.ft.com/Term?term=EBITDA

9
AccountingTools. (2022). EBITDA. Retrieved from https://www.accountingtools.com/articles/2017/5/5/ebitda
10
The Motley Fool. (2019). EBITDA vs. Free Cash Flow: Which Is More Important?. Retrieved from
https://www.fool.com/investing/2019/04/29/ebitda-vs-free-cash-flow-which-is-more-important.aspx

11
Wall Street Oasis. (n.d.). EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). Retrieved
from https://www.wallstreetoasis.com/finance-dictionary/ebitda
If a company doesn’t report EBITDA, it can be easily calculated from its financial statements.

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:

EBITDA = Net Income + Taxes + Interest Expense + Depreciation & Amortization; and

EBITDA = Operating Income + Depreciation & Amortization

EXAMPLES

1. 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.
2. Company XYZ’s depreciation and amortization expense are incurred from using its
machine that packages the candy the company sells. It pays 5% interest to debtholders
and has a tax rate of 50%. What is XYZ’s Earnings Before Interest Taxes Depreciation
and Amortization?

Interest expense = 5% * $40,000 (operating profit) = $2,000

Earnings Before Taxes = $40,000 (operating profit) – $2,000 (interest expense) = $38,000

Tax Expense = $38,000 (earnings before taxes) * 50% = $19,000

Net Income = $38,000 (earnings before taxes) – $19,000 (tax expense) = $19,000
Second Step: Find the depreciation and amortization expense

In the Statement of Cash Flows, the expense is listed as $12,000.

Since the expense is attributed to the machines that package the company’s candy (the
depreciating asset directly helps with producing inventory), the expense will be a part of their
cost of goods sold (COGS).

Third Step: Calculate Earnings Before Interest Taxes Depreciation and Amortization

EBITDA = Net Income + Tax Expense + Interest Expense + Depreciation & Amortization
Expense

= $19,000 + $19,000 + $2,000 + $12,000

= $52,000

EBITDA = Revenue – Cost of Goods Sold – Operating Expenses + Depreciation & Amortization
Expense

= $82,000 – $23,000 – $19,000 + $12,000

= $52,000

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.12

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

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

12
Barron’s. “Liberty Media: Better Than Berkshire
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.13

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.

EBITDA gained notoriety during the dot-com bubble when some companies used it to
exaggerate their financial performance.14

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.

ANALYSIS AND ASSESSING THE SUSTAINABILITY OF COMPANIES BASED ON


EBITDA

Look at trends in EBITDA over time: Analyzing a company's EBITDA over several years can
provide insights into its sustainability. If EBITDA is consistently increasing, it may be a sign of
sustainable growth. However, if EBITDA is volatile or decreasing, it may indicate that the
company is struggling to maintain profitability.15

Compare EBITDA to industry peers: Comparing a company's EBITDA to its industry peers can
help determine if it is performing well relative to competitors. However, it's important to
consider that EBITDA can vary significantly across industries, so this comparison should be
done with caution.16
13
William N. Thorndike Jr., via Google Books. “The Outsiders: Eighthttps://books.google.co.in/books?
id=psSLKgV8IO4C&pg=PA91&lpg=PA91&dq=malone+ebitda&redir_esc=y#v=onepage&q=malone
%20ebitda&f=false
14
Forbes. “EBITDA Addiction Growing at Dot-Comshttps://www.forbes.com/2001/05/03/0503simons.html?
sh=ac11a5c23e51
15
Investopedia. (2021). Earnings Before Interest, Taxes, Depreciation, and Amortization - EBITDA. Retrieved from
https://www.investopedia.com/terms/e/ebitda.asp

16
Financial Times Lexicon. (n.d.). Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA).
Retrieved from https://lexicon.ft.com/Term?term=EBITDA
Consider the company's EBITDA margin: The EBITDA margin, which is EBITDA divided by
revenue, can help assess a company's profitability. A higher EBITDA margin indicates that the

company is generating more earnings from each dollar of revenue. However, it's important to
also consider factors such as the company's operating expenses and capital expenditures.17

Evaluate the company's debt levels: High levels of debt can negatively impact a company's
sustainability, as interest expenses can reduce profitability. By analyzing a company's EBITDA,
you can determine if it has enough earnings to cover its debt obligations. A commonly used
metric for this analysis is the debt/EBITDA ratio, which compares a company's total debt to its
EBITDA.18

METHODS OF USING EBITDA

There are several methods of using EBITDA that can provide insights into a company's financial
performance. Here are a few examples:

Valuation: EBITDA can be used as a valuation metric to determine a company's enterprise value
(EV). The EV is calculated by multiplying a company's EBITDA by an appropriate multiple,
which is determined by factors such as industry, company size, and growth prospects. The
resulting value can be used to compare the company's valuation to its peers or to historical
valuations.19

Performance analysis: EBITDA can be used to analyze a company's financial performance by


comparing it to historical data or to industry peers. This analysis can provide insights into a
company's profitability, operating efficiency, and ability to generate cash flow.

17
The Motley Fool. (2020). EBITDA Margin. Retrieved from https://www.fool.com/knowledge-center/ebitda-
margin.aspx

18
AccountingTools. (2022). Debt/EBITDA ratio. Retrieved from
https://www.accountingtools.com/articles/2017/5/10/debtebitda-ratio

19
Investopedia. (2021). Enterprise Value (EV). Retrieved from
https://www.investopedia.com/terms/e/enterprisevalue.asp
Capital expenditure analysis: EBITDA can be used to analyze a company's capital expenditure
(CapEx) needs. By subtracting a company's CapEx from its EBITDA, you can determine the
amount of cash that the company has available to service debt, pay dividends, or invest in growth
opportunities.

Debt coverage analysis: EBITDA can be used to assess a company's ability to service its debt.
By dividing a company's EBITDA by its interest and principal payments, you can determine its
debt service coverage ratio (DSCR). A DSCR of less than 1 indicates that the company may have
difficulty meeting its debt obligations, while a ratio of 1.5 or higher is considered healthy.20

CONCLUSIONS

The advantages of calculating EBITDA as an indicator of the company's sustainability are


obvious. A business that has a large volume of capital expenditures wears unprofitable,
"undermining" the stability of the economy of any country. However, calculating EBITDA,
taking into account upfront costs, allows us to show the company's sustainability more
realistically. And enterprises that have a high share of depreciation and amortization costs for
equipment and other long-term assets in their prime costs can firmly declare their sustainability.
Because the assessment of a business's ability to pay off its liabilities and reinvest funds for
future business development is based on EBITDA.

Moreover, as the example shown, EBITDA can identify the most stable company among
enterprises that have an equal financial position at first glance.

Operating income tends to be more stable than expected earnings, gross profit before interest and
taxes (EBIT) tends to be more stable than operating income, and EBITDA tends to be more
stable than EBIT.

Less volatile indicators confirm the company's stability, which is extremely important when
evaluating a business.

20
Corporate Finance Institute. (n.d.). Debt Service Coverage Ratio (DSCR). Retrieved from
https://corporatefinanceinstitute.com/resources/knowledge/finance/debt-service-coverage-ratio-
dscr/
A low level of net profit cannot reliably evidence the company's stability. Only operating
incomes shows a complete picture of the financial stability of companies.

In this regard, when assessing the sustainability of companies, financial analysts must research
many measures to get maximum information to identify the real picture of the company's
sustainability.

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1. T. Mukhambetov, F.Yerdavletova, ICMLG (2014)

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4. R. Oliveira, J.Felipe, V.Junior, D. Baiardo, R.Ponte, V. Maria, M. Domingos, S. Rejane,


Revista Ambiente Contabil, 9(2) (2017)

5. A. J. Pereira, L. Lucena, W. Glaucio, Sistemas&Gestao, 12(2) (2017) 6. S. S. Ahmed,


Global business review, 16(5) (2015).

7. C.-Serrano, B.-Contell, L.-Serer, R.-M. Andrea, Journal of business research, 89 (2018)

8. J. P. Damijan, Post-communist economies, 30(2) (2018)

9. De Carvalho, A. Oliveira, R. Ivano, S. Cirani, C. Brito, C. R. Fabiano, International


Journal of innovation, 4(1) (2016)

10. P. F. Kaznacheev, N.V. Kjurchiski, R.V. Samoilova, Economic policy, 12(6) (2017)

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