EBITDA, or earnings before interest, taxes, depreciation, and amortization, is a financial performance indicator that can be used instead of net income in certain situations. On the other hand, EBITDA can be deceiving because it does not include the cost of capital investments such as property, facilities and equipment.
By adding back interest expense and taxes to income, this figure also removes debt-related expenses. Nonetheless, because it may reflect earnings before accounting and financial deductions, it is a more accurate indicator of business performance.
Simply put, EBITDA is a profitability metric. Although there is no legal requirement for corporations to publish their EBITDA, it can be calculated and reported using information from their financial statements, in accordance with U.S. generally accepted accounting principles (GAAP).
The income statement includes figures for income, taxes and interest, while depreciation and amortization are usually included in the notes to the operating profit or cash flow statement. Starting with operating profit, also known as earnings before interest and tax (EBIT), and adding back depreciation and amortization is a common shortcut for calculating EBITDA.
EBITDA Calculation and Formula
EBITDA is calculated in a straightforward manner using data from a corporation’s income statement and balance sheet. EBITDA is calculated using two formulas: one that uses operating income and another that uses net income.
EBITDA = Net Income + Taxes + Interest Expense + Depreciation and Amortization
And
EBITDA = Operating Income + Depreciation and Amortization are two EBITDA calculations.
Understanding EBITDA
EBITDA is net income (or earnings) adjusted for interest, taxes, depreciation and amortization. Since it excludes the effects of finance and capital expenditure, EBITDA can be used to examine and compare profitability across organizations and industries. EBITDA is often used in valuation ratios and can be compared to sales and enterprise value.
Interest expense and (to a lesser extent) interest income are added back to net income, thereby neutralizing the cost of debt as well as the tax impact of interest payments. If the company has a net loss, income tax is also added back to net income, which doesn’t always boost EBITDA. When a company’s net income is not particularly outstanding (or positive), it focuses on its EBITDA performance.
Depreciation and amortization accounts are used by businesses to deduct the cost of property, plant and equipment, as well as capital investments. Amortization is a method of accounting for the cost of software development and other intellectual property. This is one reason EBITDA is used by early-stage technology and research companies when talking with investors and analysts.
When the capital expenditure categories are eliminated, the management team will claim that EBITDA provides a better picture of profit growth trends. While using EBITDA as a growth figure is not necessarily misleading, it can sometimes obscure a company’s true financial performance and threats.
Why Use EBITDA?
EBITDA is a popular statistic for estimating cash flow. By multiplying this by a valuation multiplier collected from equity research reports, industry transactions, or M&A, it can give an analyst a rapid estimate of a company’s value as well as a valuation range.
In addition, investors can use EBITDA to assess a company even when it is not profitable. This statistic is popular among private equity firms because it allows them to compare companies in the same industry. It is used by business owners to evaluate their own performance in comparison to their competitors.
What are the drawbacks of EBITDA?
Following are some of the disadvantages of EBITDA:
Since debt expenses are not included in EBITDA, the resulting figures are considered misleading. It does not disclose a corporation’s actual earnings or liquid assets.
Many business owners use it to hide their poor financial judgment and financial flaws.
It has no effect on high-interest credit card debt.
When evaluating a company’s financial performance, it does not account for depreciation and EBITDA amortization as actual expenses.
Companies must employ additional financial parameters in addition to EBITDA to arrive at a more accurate valuation.
As a result, EBITDA is a good way to measure a company’s core profit trends because it includes non-core components. However, both investors and business owners must employ other, more complete financial criteria to arrive at a more comprehensive financial analysis.
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