Earnings before interest, taxes, depreciation and amortization

A company's earnings before interest, taxes, depreciation, and amortization (commonly abbreviated EBITDA,[1] pronounced ,[2] ,[3] or [4]) is an accounting measure calculated using a company's net earnings, before interest expenses, taxes, depreciation and amortization are subtracted, as a proxy for a company's current operating profitability, i.e., how much profit it makes with its present assets and its operations on the products it produces and sells, as well as providing a proxy for cash flow.

Although EBITDA is not a financial measure recognized in generally accepted accounting principles, it is widely used in many areas of finance when assessing the performance of a company, such as securities analysis. It is intended to allow a comparison of profitability between different companies, by discounting the effects of interest payments from different forms of financing (by ignoring interest payments), political jurisdictions (by ignoring tax), collections of assets (by ignoring depreciation of assets), and different takeover histories (by ignoring amortization often stemming from goodwill). EBITDA is a financial measurement of cash flow from operations that is widely used in mergers and acquisitions of small businesses and businesses in the middle market. It is not unusual for adjustments to be made to EBITDA to normalize the measurement which allows buyers to compare the performance of one business to another.[5]

A negative EBITDA indicates that a business has fundamental problems with profitability and with cash flow. A positive EBITDA, on the other hand, does not necessarily mean that the business generates cash. This is because EBITDA ignores changes in Working Capital (usually needed when growing a business), in capital expenditures (needed to replace assets that have broken down), in taxes, and in interest.

Some analysts do not support omission of capital expenditures when evaluating the profitability of a company: capital expenditures are needed to maintain the asset base which in turn allows for profit. Warren Buffett famously asked: "Does management think the tooth fairy pays for capital expenditures?"[6] Depreciation is often a very good approximation of the capital expenditures required to maintain the asset base, so it has been argued that EBITA ("Earnings before Interest, Taxes and Amortization) would be a better indicator.

EBITDA margin refers to EBITDA divided by total revenue (or "total output", "output" differing "revenue" by the changes in inventory).[7]

Use

Apart from the use mentioned above, EBITDA is widely used in loan covenants, mostly in the following two metrics:

  1. Leverage: Debt/EBITDA. This metric measures the amount of debt in relation to the EBITDA (i.e., how does the debt relate to the operational profit generating ability of the company). Whilst there is no absolute target and whilst leverage ratios differ widely, it can probably be argued that a leverage >3 is unhealthy for most businesses.
  2. Interest Cover: (EBITDA/Interest Expense). This metric measures the ability of a company to generate profit out of its operations to cover interest payments. Again, there is no absolute target for this value, as the ratio that is required obviously depends on taxes, working capital needs, capital expenditures and the repayment needs of the principal. However, it is clear that a ratio <1 is not sustainable for long.

Misuse

Over time, EBITDA has mostly been used as a calculation to describe the performance in its intrinsic nature, which means ignoring every all cost that does not occur in the normal course of business. In spite of the fact this simplification can be quite useful, it is often misused, since it results in considering too many cost items as unique, and thus boosting profitability. Instead, in case these sort of unusual costs get downsized, the resulting calculation ought to be called "adjusted EBITDA" or similar.[8]

Because EBITDA (and its variations) are not measures generally accepted under U.S. GAAP, the U.S. Securities and Exchange Commission requires that companies registering securities with it (and when filing its periodic reports) reconcile EBITDA to net income in order to avoid misleading investors.[6]

In another attempt to boost EBITDA, some companies have reverted to activate development efforts in the profit and loss statement. This effectively increases total output and hence increases EBITDA. Such development costs are then recorded as capital expenditures. Instead of EBITDA, a view on EBITA (as discussed above) would eliminate such an artifact.

See also

References

  1. ^ "EBITDA - Financial Glossary". Reuters. 2009-10-15. Retrieved 2012-02-09. 
  2. ^ Professional English in Use Finance, Cambridge University Press
  3. ^ "Pronunciation of ebitda - how to pronounce ebitda correctly". Howjsay.com. 2006-10-29. Retrieved 2012-01-21. 
  4. ^ "EBITDA - alphaDictionary * Free English On-line Dictionary". Alphadictionary.com. 2001-05-03. Retrieved 2012-01-22. 
  5. ^ http://exitpromise.com/adjusted-ebitda/
  6. ^ a b "Top Five Reasons Why EBITDA Is A Great Big Lie". Forbes. 2011-12-28. Retrieved 2012-11-15. 
  7. ^ "What is EBITDA?". BusinessNewsDaily. 2013-05-09. Retrieved 2014-11-15. 
  8. ^ "EBITDA Calculations and Reconciliation". TigerLogic. Retrieved 2014-02-08. 

Further reading

  • McLaney, Eddie; Atrill, Peter (2012-06-14). Accounting: an Introduction (6 ed.). Pearson. ISBN . 

External links

  • Investopedia definition of EBITDA
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