EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is perhaps the most important financial metric used in valuing companies.
EBITDA as a metric was pioneered by companies like Donaldson Lufkin and Jenrette (DLJ) during the high yield bond boom of the 1970s and 80s. This gave the impression that companies were less leveraged than they otherwise might appear. Treating EBITDA as cash or cashflow is a dangerous thing to do as there are many mandatory expenditures which have to be met – such as interest, tax and capital expenditure (Capex).
As we discuss EBITDA, you will see that EBITDA is always potentially compromised as a measure, so it can’t be used in isolation.
What is EBITDA?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. It is a financial metric used to measure a company’s operating performance and profitability from its core business operations.
Corporate financiers and analysts seem to treat EBITDA as a proxy for “Cash profit from operations” and EV/EBITDA is the most widely quoted valuation metric in corporate finance. EBITDA is a key metric used by the rating agencies in assessing creditworthiness and it is used as a standard metric in financial covenants or undertakings in loan documents.
For example, a borrower, when it borrows from a bank, will commit to maintain its ratio of debt/EBITDA below a particular threshold. For investment grade companies this will typically be in the 3.5X-4.0X range. Similarly, they will commit to a minimum EBITDA/Interest cover.
The formula for EBITDA is:
EBITDA = Net Income + Interest + Taxes + Depreciation & Amortization.
This immediately gives rise to problems as EBITDA, although often quoted by companies in their annual reports, is not a GAAP measure. That means there is no definition of EBITDA in generally accepted accounting principles.
It is very common for companies to quote “adjusted EBITDA” figures, where the EBITDA in question is before “exceptional items”. The definition of “exceptional items” is a judgement made by management.
Or more simply:
EBITDA = Operating Profit + Depreciation & Amortization
Interpreting EBITDA in Corporate Finance and credit
EBITDA is an important metric in corporate finance and credit analysis used to evaluate profitability for the following reasons:
- Assesses profitability from core operations – By removing interest, taxes, depreciation, and amortization, EBITDA provides an alternative view of profitability from a company’s core operations. When comparing operating performance of two similar companies, using EBIT as a metric, i.e. operating profit after depreciation, is equally or more important. Depreciation is an economically meaningful expense – in a capital-intensive industry, it is a major operating expense. We can’t understand the full picture of operating profitability – i.e. the ability of a company to turn $1 of sales into so many Cents of operating profit without taking account of depreciation.
- Measures cash flow potential – Since EBITDA removes non-cash expenses like depreciation and amortization, it gives an idea of how much cash flow is generated from operations. However, EBITDA can’t really be used on its own. If we take a metric like net Debt/EBITDA, this is strongly linked to the credit rating of a company and its likelihood of default, making it a particularly good risk measure. As a measure of cashflow, EBITDA is less useful: A company will have to meet interest expenses, pay tax and do capital expenditure to maintain its business. None of these are discretionary, so EBITDA is a long way from actual cash available to repay debt principle or pay dividends with. One of the biggest adjustments to get from operating profit (EBIT) as a metric to actual Cash From Operations (CFO) is the change in working capital. In a working capital-intensive industry, big swings in commodity prices and problems with production processes can dominate cash flow generation. On its own, EBITDA only gives us a small part of the picture. The Rating Agencies prefer to use more complete measures of cashflow, such as Cash from operations (CFO), Free operating cashflow (FOCF) and Funds from operation (FFO). This last metric is basically cash from operations but before change in working capital. Rating agencies use this as a proxy for recurring operating cashflow generation.
- Determines value of acquisition targets – EBITDA multiples are often used in valuations of potential acquisition targets. Comparing EBITDA across companies in a sector helps determine value.
Disadvantages of EBITDA
- EBITDA is Susceptible to manipulation – it is not a GAAP measure. EBITDA can be inflated by the use of “exceptional items”. Management can, at the stroke of a pen remove expenses from the calculation. This can be justified that a provision for future costs – like restructuring – is not a cash outflow now. Cash from operations is after the impact of the cash outflows from previous year’s provisions being realised – i.e. this year we actually paid off the staff we planned to lay off (and provided for) last year. The EBITDA figures will never include continuing uses of exceptionals. In the same way, a company may make payments to cover pension liabilities. These are a continuing cash outflow related to operations. They will be reflected in Cash from operations, but not in EBITDA. This “abuse” of EBITDA is actually restricted in loan documentation for highly leveraged companies. It is common for borrowers to limit “adjustments” to EBITDA to no more than 20% of the unadjusted figure.
- Doesn’t measure cash flow – While a cash flow proxy, EBITDA does not directly represent cash on hand.
- Ignores capital investments – EBITDA removes depreciation so it doesn’t account for the cost of asset replacements.
EBITDA vs Other Financial Metrics
While useful, EBITDA has limitations as a profitability metric. It should be considered alongside other metrics to obtain a complete financial picture. Some key metrics to use with EBITDA include:
- Net income – the final profitability after all expenses, the bottom line.
- Operating income – profit after operating expenses but before interest and taxes and profit measures like operating margin or EBIT.
- Gross margin – revenue remaining after accounting for costs of goods sold.
- Return on assets (ROCE) – net income divided by capital employed. Credit rating agencies, use ROCE as one of their most important operating profit metrics. This is EBIT divided by Capital Employed, not EBITDA. Capital employed is Net debt + Equity.
- Return on equity (ROE)– net income divided by average shareholder equity.
- Earnings per share (EPS) – net income divided by total shares outstanding.
Exercises and Examples for Calculating EBITDA
Below are some examples and exercises to practice calculating and interpreting EBITDA:
Company A has:
Net Income: $45 million
Interest Expense: $10 million
Tax Expense: $15 million
Depreciation & Amortization: $20 million
EBITDA = $45 + $10 + $15 + $20 = $90 million
Company B has:
Revenue: $500 million
Operating Expenses: $350 million
Interest Expense: $30 million
Tax Expense: $50 million
Depreciation & Amortization: $40 million
Operating Income = Revenue – Operating Expenses = $500 – $350 = $150 million
EBITDA = Operating Income + Depreciation & Amortization
= $150 + $40 = $190 million
In summary, EBITDA is a widely used financial metric that measures a company’s core operational profitability by removing interest, taxes, depreciation, and amortization. It provides a useful if not exclusive basis for comparing profitability across firms and assessing cash flow potential. However, EBITDA does have limitations and should be considered alongside other metrics for a complete analysis. Proper application of EBITDA involves calculating it accurately, making judgements about the validity of “adjustments made by management to interpret it appropriately, and using it in conjunction with other measures, while also taking into account external factors and industry variations to facilitate nuanced financial analysis.