EBITDA is used to evaluate the performance of a business before the impact of financing decisions. It also approximates the operational results of a business on a cash flow basis. For both reasons, it is one of the most popular ways to examine the results of an entity.
How to Calculate EBITDA
The following calculation for EBITDA is a simple one, since it exactly follows the acronym:
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.
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.
All of the preceding information is derived from the income statement of the business under review.
EBITDA is a subset of the net income information presented in a company's income statement, and is designed for three purposes:
- To yield a rough estimate of a company's cash flow from operations
- To provide a basis for comparison between different companies that strip away financing and non-cash items
- To provide 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.
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.
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.
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.