EBITDA means Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a measure of a company's financial performance which is use as an alternative to net income.
The concept above is calculated by taking a company's earnings before interest, taxes, depreciation, and amortization are deducted from the total revenue. The calculation is designed to remove the effects of different financing arrangements and accounting measures that are used to calculate the net income.
EBITDA is a non-GAAP measure and its use could be of high report under IFRS or US GAAP due to its wide application in financial markets.
The formula for EBITDA is as follows:
EBITDA = revenue - (operating expenses + depreciation and amortization expenses + interest expenses + taxes)
By removing all non-operating items and expenses such as financing charges and taxes, this calculation helps investors and analysts evaluate the operating profitability of a business separate from financial decisions and components. By doing so, a better comparison of profits between different companies and over different periods of time could be achieved.
There are several advantages of using EBITDA instead of net income in financial analysis:
- By removing non-operating and non-cash items, the effect of different financing arrangements and accounting differences between companies could be ignored.
- EBITDA also allows investors and analysts to have a better understanding of the operating performance of a company, prior to the financial decisions made by the company's management.
- The calculation also provides a better comparison between different companies in different sectors.
- Lastly, EBITDA favors companies that have more debt as it removes interest and amortization charges that may otherwise affect their profitability.
EBITDA measures which shows how much money a company makes and calculates the profitability of a company by excluding any costs related to its financial structure such as taxes, interest expenses and depreciation.
It represents the operating cash flow of a company and is focuses exclusively on the earnings aspect of the profitability. This measure is useful to evaluate the quality of a company's earnings before the effect of financial decisions and non-recurring items.
EBITDA presented a major flaws which although it concentrates on the core of a business and is considered as an acceptable approximation of net cash profit of a limited entity, it is also fails to give a complete picture of a company's performance by only taking into account non-operating and non-cash activities.
For this reason and, despite its wide use in the market, EBITDA does not account correctly for profits and losses in a business and it simplifies too much the core business but put aside also other different aspects which a complete financial report must consider. Therefore, in order to complete analyze a company's earnings is recommended to supplement EBITDA with other financial statements such as income statement depending if a business has complicated ownership and capital structure.
EBITDA and EBIT (earnings before interest and taxes) are both measurements of profitability. They both measure a company's profits or losses but EBITDA is more comprehensive as it also takes into consideration non-cash items such as depreciation and amortization. Both methods also remove any extraordinary items from their calculations, but EBIT still includes interest and tax payments, which are excluded from EBITDA.
So, for this reason, EBITDA is generally being considered a better metric when analysts are looking to benchmark a company's performance against its competitors in the same industry as it ignores the impact of financial decisions, regulations and capital structure on profitability metrics. As EBITDA is solely focused on the operational performance of the company, the only way comparison could be done is by taking out the differences in the capital structure of companies which gives investors a more reliable view of the company's performance.
Operating cash flow is different to EBITDA as the former involves only cash inflows and outflows from business activities. Also, EBITDA takes into account non-cash expenses which are excluded in operating cash flow calculations. This exists because non-cash expenses such as depreciation are still expensed for cost reporting and tax purposes despite not having any impact on the actual cash flow of the business at the time of their recognition.
For this reason, both EBITDA and operating cash flow should be taken into account when assessing the financial health of a company as they both give different insights regarding the same business activities and each has its own specifications.
EBITDA is most commonly used to examine a company's core profitability and operating cash flow. Analysts and investors use it as an indicator of a company's performance and financial health. It has become a popular metric as a result of the ability to analyze the financial performance of different companies without the impact of short-term finances on the reported earnings, and as a result has increases pervasive in financial reporting. The goal of this measure is to get a more accurate assessment of the corporation's earnings potential.
EBITDA is also used in a variety of financial ratios such as the EBITDA margin and EBITDA to net income ratio. These are useful in assessing the viability and quality of a company's funds. It is also highlighted by many credit rating agencies and investment agencies since heavily investing in non-cash activities such as depreciation and amortization resulting in superior profitability position impairs cash flow.
EBITDA could also be used in leveraged buyouts and may be referred often during mergers and acquisitions process.
Furthermore, bankers usually agree to lend money based on the company's EBITDA potential and commonly may ask for financial statements accompanied with EBITDA notes in order to provide more clarity on the quality of the company's core earnings.