EBITDA – Earnings Before Interest Taxes Depreciation & Amortization EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It is a measure of cash flow to the firm, to both equity and debt holders. EBITDA is used to analyze a company’s operating profitability. It came into prominence in the 1980s as leveraged buyout investors used it to calculate whether companies could pay back the interest and retire debt on financed deals after a restructuring. Investors promoted EBITDA as a tool to determine if a company could service its debt in the near term.
Let us understand the calculation of EBITDA
- EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
- EBITDA = EBIT (Earnings before interest & taxes) + Depreciation + Amortization
WeaknessesEBITDA is not recognized by IFRS or US GAAP. It is an accrual accounting measure that can be easily manipulated by aggressive accounting policies. It can be manipulated to make companies look financially healthy as it does not include expenses including depreciation and amortization. The choice of leasing method affects EBITDA. It is a poor proxy for cash flow. If working capital is growing, it will overstate cash flow from operations. It ignores how different revenue recognition policies affect cash flow from operations. It ignores changes in working capital and fixed capital. It is not very strongly linked to valuation theory.
Impact of EBITDA on company’s financesA positive EBITDA indicates that the company is profitable and a negative EBITDA indicates that the company is having operational problems. Let us understand how EBITDA analyzes the financial health of the company using the following financial ratios:
- EBITDA / Revenues:
- Operating cash flow / EBITDA:
- EBITDA / financial expense:
- Net debt / EBITDA:
Adjusted EBITDAAdjusted EBITDA gives a true economic picture of the company. Adjusting or normalizing EBITDA is a process to see what would have been the earnings of the company if those exceptional items were not there. Non–operating expenses and one-time charges to be adjusted are restructuring charges & provisions, litigation charges, loss or profit on the sale of assets, gains or losses associated with accounting changes, losses due to fire, earthquake, or floods, and insurance claim proceeds.
ValuationAdjusted EBITDA is used in Relative valuation as an enterprise multiple to measure the performance of the company.
- Enterprise Value to EBITDA (EV / EBITDA)
- Total Invested Capital / EBITDA (TIC/EBITDA)
Financial ModelingEBITDA is used in financial modeling for calculating free cash flows
- FCFF (Free cash flow to the firm) = EBITDA (1-tax rate) + Dep * tax rate – FCInv – WCInv
- FCFE (Free cash flow to equity) = EBITDA (1 – Tax rate) + Dep (Tax rate) – Int (1 – Tax rate) – FCInv – WCInv + Net borrowings
Where Dep is depreciation FCInv is Fixed Capital Investment WCInv is Working Capital Investment Int is InterestEBITDA is a poor proxy for free cash flows. EBITDA does not include the cash taxes paid by the firm and net borrowings. It does not subtract interest, working capital, and fixed capital investments.