Earnings before interest, taxes, depreciation and amortization

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EBITDA «ee-bit-dah» is the acronym for Earnings before Interest, Taxes, Depreciation, and Amortization. It is a non-GAAP metric that is measured exactly as stated. All interest, tax, depreciation and amortization entries in the Income Statement are reversed out from the bottom line Net Income. It purports to measure cash earnings without accrual accounting, canceling tax-jurisdiction effects, and canceling the effects of different capital structures.

EBITDA differs from the operating cash flow in a cash flow statement primarily by excluding payments for taxes or interest as well as changes in working capital. EBITDA also differs from free cash flow because it excludes cash requirements for replacing capital assets (capex).

EBITDA Margin refers to EBITDA divided by total revenue. EBITDA margin measures the extent to which cash operating expenses use up revenue.

Use by private equity investors

In the process of purchase, long-life assets will be revalued to market values. Their depreciation and amortization will necessarily be changed.^{[clarification needed]} Control of the business allows the purchaser to move it to a new tax jurisdiction and to refinance its debt.^{[citation needed]}

Use by debtholders

EBITDA is widely used in loan covenants. The theory is that it measures the cash earnings that can be used to pay interest and repay the principal. Since interest is paid before income tax is calculated, the debtholder can ignore taxes. They are not interested in whether the business can replace its assets when they wear out,therefore can ignore capital amortization and depreciation.

There are two EBITDA metrics used.

1. The measure of a debt's pay-back period is Debt/EBITDA. The longer the payback period, the greater the risk. The metric presumes that the business has stopped making interest payments (because interest is added back). But it is argued that once that happens the debtholder is unlikely to wait around (say) three years to recover their principal while the business continues to operate in default. So does the metric measure anything? There is also the problem of adding back taxes. This metric ignores all tax expenses even though a good portion are cash payments, and the government gets paid first. Principal repayments are not tax-deductible.
2. One interest coverage ratio (EBITDA /Interest Expense) is used to determine a firm's ability to pay interest on outstanding debt. The greater the multiple of cash available for interest payments, the less risk to the lender. The greater the year-to-year variance in EBITDA, the greater the risk. Because interest is tax-deductible it is appropriate to back out the tax effects of the interest, but this metric ignores all taxes.

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.

Use by shareholders

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Public investors' use of EBITDA arose from their perception that accountants' measure of profits, using accrual accounting was manipulated, that a measure of cash earnings would be more reliable.^{[citation needed]}

It is true that PE can use this metric. And it is true the professional analysts using detailed discounted cash flow models should replace non-cash expenses with projected time-weighted payments. But none of that applies to retail investors' reality.^{[citation needed]}

EBITDA does NOT measure cash earnings because it omits all the tax expenses even though a good portion are cash payments. It also fails to correct for other non-cash expenses, e.g. warranty expense, bad debt allowance, inventory write-down, stock options granted.^{[citation needed]}

It does not include the cash flows from changes in working capital. Suppose a business sells all its opening inventory in a year and replaces the same number of units but at a higher price because of inflation. The profits of a company using FIFO inventory valuation will not include that extra cash cost. Suppose the business is expanding and need to stock a larger number of units. That additional cash cost is not in anyone's EBITDA measure.

When using this metric to replace accountant's earnings it presumes to measure an economic profit. But any economic profit must include the cost of capital and the degradation of long-life assets. This metric simply ignores both. Warren Buffett famously asked, "Does management think the tooth fairy pays for capital expenditures?" Depreciation may not be exact but it is the most practical method available. It succeeds in equating the positions of companies using three different ways to finance long-life assets. It can be interpreted as:^{[citation needed]}

1. 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.
2. the amount of cash required to be retained in order to finance the eventual replacement asset. Since inflation 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.
3. 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.

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 that 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).

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.^{[citation needed]}

During the dot com bubble companies promoted their stock by emphasising 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.

See also

• Earnings Before Interest, Taxes, Depreciation, Amortization, and Restructuring or Rent Costs (EBITDAR)
• Revenue
• Gross profit
• Earnings before interest and taxes (EBIT), or operating profit
• Net profit or Net income
• EV/EBITDA
• P/E ratio

References

• Investopedia definition of EBITDA