Earnings Before Interest, Tax, Depreciation and Amortization
What is EBITDA?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization and is a metric used to evaluate a company’s operating performance. It can be seen as a proxy for cash flow from the entire company’s operations.
The EBITDA metric is a variation of operating income (EBIT) that excludes non-operating expenses and certain non-cash expenses. The purpose of these deductions is to remove the factors that business owners have discretion over, such as debt financing, capital structure, methods of depreciation, and taxes (to some extent). It can be used to showcase a firm’s financial performance without accounting for its capital structure.
EBITDA focuses on the operating decisions of a business because it looks at the business’ profitability from its core operations before the impact of capital structure, leverage, and non-cash-items such as depreciation are taken into account.
It is not a recognized metric in use by IFRS or US GAAP. In fact, certain investors like Warren Buffet have a particular disdain for this metric, as it does not account for the depreciation of a company’s assets. For example, if a company has a large amount of depreciable equipment (and thus a high amount of depreciation expense), then the cost of maintaining and sustaining these capital assets is not captured.
Here is the formula for calculating EBITDA:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
EBITDA = Operating Profit + Depreciation + Amortization
Below is an explanation of each component of the formula:
Interest is excluded from EBITDA, as it depends on the financing structure of a company. It comes from the money it has borrowed to fund its business activities. Different companies have different capital structures, resulting in different interest expenses. Hence, it is easier to compare the relative performance of companies by adding back interest and ignoring the impact of capital structure on the business. Note that interest payments are tax-deductible, meaning corporations can take advantage of this benefit in what is called a corporate tax shield.
Taxes vary and depend on the region where the business is operating. They are a function of tax rules, which are not really part of assessing a management team’s performance and, thus, many financial analysts prefer to add them back when comparing businesses.
Depreciation & Amortization
Depreciation and amortization (D&A) depend on the historical investments the company has made and not on the current operating performance of the business. Companies invest in long-term fixed assets (such as buildings or vehicles) that lose value due to wear and tear. The depreciation expense is based on a portion of the company’s tangible fixed assets deteriorating. Amortization expense is incurred if the asset is intangible. Intangible assets such as patents are amortized because they have a limited useful life (competitive protection) before expiration.
D&A is heavily influenced by assumptions regarding useful economic life, salvage value, and the depreciation method used. Because of this, analysts may find that operating income is different than what they think the number should be, and therefore D&A is backed out of the EBITDA calculation.
The D&A expense can be located in the firm’s cash flow statement under the cash from the operating activities section. Since depreciation and amortization is a non-cash expense, it is added back (the expense is usually a positive number for this reason) while on the cash flow statement.