EBITDA definition
/What is EBITDA?
EBITDA is a variation on net income as a performance measure for a business. It is a contraction of Earnings Before Interest, Taxes, Depreciation, and Amortization. EBITDA approximates the operational results of a business on a cash flow basis (as opposed to its accrual basis results) by adding back certain line items to net income. EBITDA is also used to evaluate the performance of a business before the impact of financing decisions. For both reasons, it is one of the most popular ways to examine the results of an entity.
Of the four items that are excluded from the EBITDA measure, the two most critical are depreciation and amortization, since these can be extremely large numbers in capital-intensive industries, or in cases where a company has acquired a large amount of intangible assets and must amortize them. The interest line item is usually a considerably smaller figure, except in debt-heavy situations where the interest rate being charged is relatively high.
How to Calculate EBITDA
The following calculation for EBITDA is a simple one, since it exactly follows the acronym:
Net income + Interest expense + Taxes + Depreciation + Amortization = EBITDA
In essence, the EBITDA calculation adds back all non-cash and non-operational expenses to the net income figure. The interest and tax line items that are excluded from the measure are not directly related to company operations, while the depreciation and amortization line items are non-cash items.
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How to Obtain EBITDA Information
All of the preceding information is derived from the income statement of the business under review. This means that it is relatively easy for an outside party to calculate this measurement, as long as they have access to an organization’s financial statements, and the line items on those statements have not been excessively aggregated.
How to Use EBITDA
EBITDA is a subset of the net income information presented in a company's income statement, and is designed for three purposes. First, it yields a rough estimate of a company's cash flow from operations. Second, it provides a basis for comparison between different companies that strip away financing and non-cash items. And third, it provides an estimate of the funds available to pay for debt.
Unfortunately, it has also been used by companies experiencing net losses, so that they can point toward a different performance figure that shows a positive gain, which can mislead investors. In these situations, management typically represents EBITDA as being the core earnings of the business, with some non-operational issues having caused a loss for the entity as a whole.
Problems with EBITDA
There are several problems with the use of EBITDA, especially from a reporting perspective. These issues are noted below.
EBITDA is Non-GAAP
EBITDA is a non-GAAP measurement. That is, its use is not specifically authorized anywhere in GAAP. As such, it should not be included in the financial statements or accompanying footnotes issued by a business. The EBITDA measure should only be used in conjunction with the net income figure, since EBITDA can give the impression that a company is highly profitable, when in fact the net income figure may be a loss.
EBITDA Only Approximates Cash Flow
The EBITDA measure is only an approximation of company cash flow, since it incorporates revenue and expense accruals that do not reflect actual cash flows, and does not factor in any fixed asset expenditures. For a more precise view of cash flow, you should instead use the statement of cash flows, which defines the sources and uses of funds in some detail.
In short, EBITDA is a moderately useful, quick-and-easy measure that is a general indicator of a company's operational results. However, you should only use it in conjunction with a company's full set of financial statements.
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