Having a reliable measure of your company's financial health is invaluable both to you and to potential business partners. The accounting technique EBITDA — earnings before interest, taxes, depreciation and amortization — is an important standard measure of profitability.
EBITDA gained popularity in the 1980s, at the height of the leverage buyout era. What makes EBITDA valuable is that unlike standard net income calculations that use a simple formula of revenueminus expenses, EBITDA factors in other expenses, like taxes and interest. EBITDA allows analysts to generate useful comparisons between companies, and to project long-term profitability and the ability to pay off future financing.
Joseph Ferriolo, director of Wise Business Plans, says a healthy EBITDA calculation can help cinch the deal if you are interested in selling or merging your company.
"EBITDA is one of, if not the most important measures that investors consider when a company is being bought or sold," Ferriolo told Business News Daily. "If I was going to invest, my primary concern would be ensuring that the business had an audited, up-to-date EBITDA analysis."
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 tax, interest, depreciation and amortization)
Or, more simply, it equals net income plus interest, taxes, depreciation and amortization.
Because EBITDA is not a part of generally accepted accounting principles (GAAP), it may not automatically be included in a company's financial statement. However, EBITDA can be calculated using existing figures. With the EBITDA value, the business and its investors are now able to better compare profits against those of the business's competitors.
Related formulas: EBITDAR & EBITARM
Two extensions of EBITDA are EBITDAR and EBITDARM. The first one, EBITDAR, stands for earnings before interest, taxes, depreciation, amortization, and rent or restructuring costs. It is useful for companies undergoing restructuring.
The second, EBITDARM, adds rent and management fees to the EBITDA calculation. Credit rating agencies often use this 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 a company's profitability.
The main argument against relying on EBITDA as a performance indicator is that it does not account for changes in working capital. This indication of the company's liquidity fluctuates due to interest, taxes and capital expenditures. While a negative EBITDA value may indicate that the business has trouble with profitability, a positive value may not be synonymous with a healthy company, because taxes and interest are actual expenses that businesses must account for. In contrast, a company may have low liquidity if its assets are difficult to convert into cash, but still maintain a high level of profitability. Excluding working capital, as EBITDA does, can result in a misleading valuation.
EBITDA can also provide a distorted picture of how much money a company has available to pay off interest. By adding back depreciation and amortization, a company's profits can be made to appear greater than they actually are. EBITDA can also be manipulated by changing deprecation schedules to inflate profit projections. For these reasons, many believe EBITDA is used simply as a way to make a company appear more attractive to investors than it really should.
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."
For these and many other reasons, it is critical that businesses aiming to attract new investors ensure that their financial statements have been audited and verified.
"The most importantquestionfor investors and analysts is to ensure that the company's financials have been recently and thoroughly audited by a CPA," Ferriolo said.
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 result 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.
More information about EBITDA calculations and criticisms can be found on the following websites:
Additional reporting by Chad Brooks, Business News Daily senior writer.
Originally published May 9, 2013. Updated Feb. 25, 2015.