TL;DR
- EBITDA stands for earnings before interest, taxes, depreciation, and amortization
- EBITDA is not recognized by US GAAP, but most companies provide the metric to shareholders
- EBITDA and EBITDA margin are widely used metrics among investors who are trying to compare the profitability of companies within similar industries.
- Since EBITDA shows earnings without the impact of large expenses, the metric can be misleading
- A higher EBITDA and EBITDA margin can be a good sign of a company’s profitability
What is EBITDA?
EBITDA stands for earnings before interest, taxes, depreciation, and amortization and is used to evaluate the profitability of a company’s ongoing operations. Some people use the metric in place of a company’s net income or operating cash flow, because it removes the impact of expenses that could be considered unrelated to a company’s ongoing operations (i.e. interest, taxes, depreciation, and amortization). But others find the metric misleading for the same reason. EBITDA is not recognized by the US Generally Accepted Accounting Principles (GAAP), therefore a company is not required to disclose this metric. That being said, most companies will provide shareholders with this information in their quarterly reports.
Why EBITDA matters to investors
EBITDA is a widely used metric that can be useful when comparing companies within an industry, but the metric can be misleading for investors if they are not educated on what it represents.
As the name suggests, interest, taxes, depreciation, and amortization are ignored in this earnings calculation. But what does this mean? Interest expense is the coast of a loan. When a company borrows money, it is required to pay interest based on a designated interest rate. Therefore, a company that has a lot of debt, may prefer to show its EBITDA to investors, because it can showcase its net income without the high interest expense it pays. Similarly, depreciation and amortization expense is the cost of an asset. Per accounting principles, when a company buys any tangible or intangible asset (i.e. land, machinery, equipment, intellectual property, etc.), it is immediately recognized on the balance sheet. But over the lifetime of the asset, the expense is gradually recognized on the company’s income statement. If a company has a lot of capital or intangible assets, it will experience a large amount of depreciation and amortization expense on its income statement. This company may prefer to show their EBITDA to investors, because it can showcase their net income without the high depreciation and amortization expense it pays.
EBITDA may be representing an unrealistic vision of a company’s earnings, but as mentioned, the metric becomes useful when investors are trying to compare companies within an industry. Since EBITDA removes the effects of debt and non-cash expenses (i.e. depreciation and amortization), it becomes a great way to compare companies that are structured differently. Many investors use something called an EBITDA margin to draw this comparison. The EBITDA margin calculates EBITDA as a percent of overall revenue. Looking at EBITDA as a percent of revenue, allows investors to compare the performance of different sized companies within the same industry; it is an efficient “apples-to-apples” profitability metric.
How is EBITDA calculated?
To calculate EBITDA simply take a company’s net income, which is often found at the very bottom of a company’s income statement, and add back taxes, interest, depreciation, and amortization. Using the same logic, if you are given a company’s EBIT, also known as operating income, add back depreciation and amortization to calculate EBITDA. Once EBITDA is calculated, it may be useful to calculate the company’s EBITDA margin. The EBITDA margin is shown in the form of a percent and is EBITDA divided by total revenue. Revenue is often shown at the top of a company’s income statement. It is important to note that interest, taxes, depreciation, and amortization are not the only expenses a company incurs. Therefore, while EBITDA does omit the effects of certain expenses, it does not omit the effects of operating expenses. On the other hand, the total revenue is how much money is coming in before any expenses are incurred.
Is a higher or lower EBITDA better?
In terms of EBITDA and EBITDA margin, the bigger the better. Since EBITDA excludes the impact of so many expenses, the metric should be high. If a company’s EBITDA is very low, it may be a sign that the company is truly not profitable after all expenses are incurred. In this respect, many investors will look at other metrics, in addition to EBTIDA, when evaluating the financial health of a company. Similarly, a high EBITDA margin is a good sign for investors. Since the EBITDA margin represents EBITDA as a percent of revenue, a high EBITDA margin shows that a company’s operating expenses are relatively low.
Bottom line
EBITDA is an extremely common metric that many companies like to showcase. Though EBITDA can be seen as a way to evaluate the pure operating profitability of a company, the metric can be misleading to investors that are unaware of its true meaning. Since EBITDA removes the impact of interest expense, taxes, depreciation, and amortization, companies with high debt and frequent asset purchases may look more favorable through the lens of the EBITDA metric. While this metric helps investors draw comparisons and analyze profitability, it is important to note that the metric does not capture the full financial health of a company.