Earnings before Interest, Taxes, Depreciation, and Amortization
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EBITDA «ee-bit-dah» or «ee-bit-dee-eh» is an acronym for earnings before interest, taxes, depreciation, and amortization. The same calculation can be arrived at from "operating income before depreciation and amortization" (OIBDA). It is one measure of 'operating cash flow'.
It differs from the cash flow from operations found in the Statement of Cash Flow primarily by ignoring payments for taxes or interest. EBITDA does not add back many of the other non-cash operating expenses, like the Statement of Cash Flow does. EBITDA also differs from free cash flow because of the difference above, and also because it does not recognize the cash requirements for replacing capital assets. EBITDA is most useful when evaluating a company's true ability to earn a profit, and is often used to help determine whether or not to buy that company's stock.
Although there are different points of view regarding the use of this metric by equity owners, most agree to its validity when used by debtholders, or to evaluate a business's ability to handle debt[citation needed]
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[edit] Use by debtholders
EBITDA measures the cash earnings that may be applied to interest and debt retirement. The holder of debt is concerned with the business's ability to pay the interest and to repay the principal when due. Since interest is paid before profit tax is levied, then s/he should ignore taxes.[citation needed] The debtholder is not interested in whether the business can replace its assets when they wear out (assuming the term of the debt is shorter than the income-generating life of the assets), and so can ignore both capital expenditures and their amortization.[citation needed]
In practice, capital expenditures and the maintenance of assets may use up cash available for debt repayment, and so will increase risk of default. The risk may be mitigated by incorporating loan covenants restricting the borrower's ability to make certain expenditures or investments under certain conditions. Lenders will also measure the company's ability to service debt using a debt service coverage ratio.
There are two EBITDA metrics used.
- The interest coverage ratio is used to determine a firm's ability to pay interest on outstanding debt. It is calculated : EBITDA /Interest Expense. The greater the year-to-year variance in EBITDA, the greater the multiple should be.
- The measure of the pay-back period for a debt is : Debt/EBITDA. The longer the payback period, the greater the risk.
The ratios can be customized by reducing Debt by any cash on the balance sheet or by deducting maintenance capex from EBITDA to form a measure closer to free cash flow.
[edit] Use by equity owners - pro
A jocular backronym variation of the term is "Earnings, Before I Tricked the Dumb Auditors."
Depreciation
A company's Net Income is distorted by decisions that the company made in previous years. This is because of the differences between accrual accounting and cash basis accounting. Some purchases are depreciated or amortized over 20 years or more, with a negative impact on the Net Income long after the actual financial effects of the purchases have ceased. The EBITDA does not suffer this distortion, so investors can get a better idea of how profitable the company really is.[citation needed]
Depreciation of capital expenditures is a particularly strong factor. For example, if a company spends $99 million in new desktop computers for all its employees, the company will often decide to depreciate the purchase over their expected lifetime of three years. This way, in the first year, when the company calculates its "income" number, it pretends that it has only spent $33 million that year on desktop computers. The company's income number paints a more rosy and optimistic picture than actually occurred that year. In each of the second and third years, the company also pretends that it has spent $33 million per year on desktop computers. Hence, the company's financial picture was probably healthier than indicated by the income number, since the $33 million had actually already been paid out. Large adjustments to goodwill, such as adjusting by means of a write-down the carrying value of a previous purchase, generally have limited effect on operating cash flows, but can significantly effect the reported earnings; although the 'paper loss' generated may reflect a poor choice, the actual loss of value may have taken place years before.
Capital expenditures typically vary from year to year. Accrual accounting accounts for this by spreading the expense of capital investments over the years in which they will be generating value for the company. EBITDA removes this effect. Investors can use EBITDA to approximate the fundamental earning power of the company's operations while separately factoring in the projected capital expenditures needed to maintain those operations. This is valuable because of the time value of money principle. (An expenditure is less costly if it is to be made several years into the future, because during the interim period the firm can use the cash for that expenditure to generate income in other ways.)
Interest
Because EBITDA is measured before interest (which vary with the amount of debt financing), it approximates the company's earnings potential as if financed with zero debt. It corrects for the differences between company's valuations due to their capital structure. If the investor can change the capital structure of a firm (e.g., through a leveraged buyout) he first evaluates a firm's fundamental earnings potential (reflected by EBITDA or EBIT), and then determines the optimal use of debt vs. equity.
[edit] Use by equity owners - con
In layman's terms, EBITDA is called "Earnings, before all the bad stuff". Warren Buffett famously asked, "Does management think the tooth fairy pays for capital expenditures?" For many companies, capital expenditures (for example) may be required at a consistent level; excluding the associated accounting allocation may overstate the company's profitability. Similarly, amortization (write-downs of goodwill may reflect important changes in the company's business prospects. Interest and taxes both represent (in most cases) actual cash outlays.
Depreciation
The same argument applies to the purchase of long-life capital assets. Depreciation may be interpreted as:
- the allocation of the original cost, at a later date, when the asset was used to generate revenue. The time-value-of-money (same argument used above) means that depreciation may understate the cost.
- the amount of cash required to be retained in order to finance the eventual replacement asset. Since inflations is the basis for time-value-of-money, the amounts set aside today must be invested and grow in value in order to pay the inflated price in the future.
- the decrease in value of the balance sheet asset since the last reporting period. Assets wear out with use, and will eventually have to be replaced.
[edit] Unprofitable businesses
When comparing businesses with no profits, their potential to make profit is more important than their Net Loss. Since taxes on losses will be misleading in this context, taxes can be ignored. Capital expenditures and their related debt result in fixed costs. These are of less importance than the variable costs that can be expected to grow with increasing sales volume, in order to cover the fixed costs. So depreciation and interest costs are of less importance. It is likely than an unprofitable business is burning cash (has a negative cash flow), so investors are most concerned with "how long the cash will last before the business must get more financing" (resulting in debt or equity dilution). For these reasons EBITDA is the metric most appropriate.
Be clear that EBITDA is not used as a valuation metric in these circumstances. It is a starting point on which future growth is applied and future profitability discounted back to the present. Equity owners only benefit from net profits, after all the expenses are paid.
During the dot com bubble companies promoted their stock by emphasizing either EBITDA or pro forma earnings in their financial reports, and explaining away the (often poor) "income" number. This would involve ignoring one-time write-offs, asset impairments and other costs deemed to be non-recurring. 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.
A negative EBITDA figure is not meaningful when consideration valuation multiples (namely Enterprise Value/EBITDA).
