EBITDA is a calculation of a company's financial health. The formula is essentially net income with interest, taxes, depreciation and amortization added back to it.
Credit: OPOLJA | Shutterstock
EBITDA is a relatively new method of calculating a company's financial health. EBITDA — which stands for earnings before interest, taxes, depreciation and amortization — is designed to show the profitability of a business' core operations. Because businesses use different accounting standards, EBITDA makes it easier to compare one business against another.
Unlike standard calculations for net income that use a simple formula of revenue minus expenses, EBITDA factors in other expenses, like taxes and interest. This doesn't necessarily show how profitable a business is overall, but how profitable the operations aspect of the business is.
The formula has been widely used for the past 30 years. It was in the 1980s, at the height of the leverage buyout era, that companies started using the calculation to show what they considered to be a better indication of business's long-term profitability and ability to pay off future financing. Investors used these calculations to help determine if a company was worth buying or lending money to.
While EBITDA isn't automatically included in every income statement, it can be calculated using different pieces of the statement. To calculate EBITDA, a business must know its income, expenses, interest, taxes, deprecation — the loss in value of operational assets, such as equipment — and amortization, which is expenses for intangible assets, such as patents, that are spread out over a number of years. With those numbers in hand, the formula is:
EBITDA = Revenue – Expenses (excluding interest, taxes, depreciation and amortization)
Basically, EBITDA is net income with interest, taxes, depreciation and amortization added back to it. With its EBITDA, a business is now able to better compare its profits against what others companies are producing.
Related formulas: EBITDAR & EBITARM
Two extensions of EBITDA are EBITDAR and EBITDARM. EBITDAR stands for earnings before interest, taxes, depreciation, amortization and rent or restructuring costs. It is useful for companies undergoing restructuring. EBITDARM adds rent and management fees to the EBITDA calculation. It is often used by credit rating agencies to make comparisons of companies that carry a high debt load.
Arguments against EBITDA
While many companies find EBITDA to be a good indication of performance, others believe the calculations can be quite deceptive and not representative of how profitable a company may or may not be. The main argument against relying on EBITDA as a performance indicator is that it is not a determinant of cash flow. EBITDA and cash flow aren't interchangeable because taxes and interest are actual expenses that businesses must account for. Factoring them out of the equation can result in a misleading company valuation.
EBITDA also can provide a distorted picture of how much money a company has to pay off interest. By adding back in depreciation and amortization, a company's profits look much greater than they actually are. Other arguments against using EBITDA are that it is a misleading measure of liquidity, that it doesn't factor in quality of earnings and that it can easily be manipulated, by changing deprecation schedules, to inflate profit projections. Many believe EBITDA is used simply as a way to make a company appear more attractive to investors than it really is.
In a case against using EBITDA as a main determinant of cash flow, Moody's Investor Service wrote in a special report on the issue that "EBITDA can drift from the realm of reality." Also, EBITDA is not considered a useful measure under generally accepted accounting principles (GAAP).
One way to get a more realistic profit picture is to calculate EBITDA margin. To determine EBITDA margin, a business must first calculate its EBITDA and then divide that number by total revenue.
EBITDA Margin = EBITDA ÷ Total Revenue
This formula helps show how much operating expenses are eating into a company's profits. In the end, the higher the EBITDA margin, the less risky a company is considered financially.