What is EBITDA? How does it impact your company’s finances?

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

Weaknesses

EBITDA 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 finances

A 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:

Indicates the operating profitability of the business, as it excludes interest, taxes, and non-cash charges in the form of depreciation and amortization. It is used by a security analyst.

• Operating cash flow / EBITDA:

Also called cash conversion ratio, shows the efficiency of the company to convert EBITDA into cash.

• EBITDA / financial expense:

Also called interest coverage ratio. It indicates the firm’s ability to meet interest obligations, liquidity and amount of debt in the company. A low ratio is a danger signal and indicates excessive use of debt. A high ratio implies that the company can easily meet its interest obligations.

• Net debt / EBITDA:

Indicates the company’s solvency, by measuring the amount of time taken to repay debt.  

Adjusted EBITDA

Adjusted 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.

Valuation

Adjusted EBITDA is used in Relative valuation as an enterprise multiple to measure the performance of the company.

• Enterprise Value to EBITDA (EV / EBITDA)

Enterprise value is the sum of market capitalization, the market value of debt, non-controlling interest, and preferred stock and deducting cash and cash equivalents. EV / EBITDA is the most widely used valuation metric for most industries. As EBITDA is treated as proxy operating ash flows, EV/ EBITDA states how much the buyer has to shell out to acquire the proxy cash flows of the company. It is unaffected by the company’s capital structure, taxes, and any distortions that may arise from differences in depreciation & amortization among different companies. Capital intensive industries like manufacturing, oil & gas, telecom, and industrial goods, where there is a huge amount of capital expenditure, EV / EBITDA multiple is preferred. Useful for comparing firms with different degrees of leverage and is usually positive.

• Total Invested Capital / EBITDA (TIC/EBITDA)

TIC is the market value of the company’s equity and debt.

Financial Modeling

EBITDA 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 Interest

EBITDA 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.

Conclusion

EBITDA is used to make comparisons among companies and assess the financial health of companies. It focuses on operating decisions and is not impacted by accounting and financing decisions. It is used in valuation and financial modeling. It is only a single indicator of the company’s financial condition. For estimating the complete picture of a company’s financial condition other measures must also be looked at including net income and EBIT.

Author: Rabia J. –  Sr. Analyst