EBITDA means measuring the change in business income while excluding non-business expenses.
The essential aspects of any business are, undoubtedly, its working strategy and the business owner’s extensive analytical measures to assess the performance. Multiple business stages require different levels of analysis and assessment. Before starting the business, SWOT and PEST examinations help chart out a company’s modus operandi. In that aspect, the profitability of a company in a market, where one’s profit thrives at the other’s downfall, needs to be analysed through the cautious lenses of economic parameters. And that is what we are here to learn about EBITDA.
What is EBITDA?
EBITDA calculates the profitability of a company in the industry by essentially calculating the company’s net income before the numerous tax and other forms of deductions. In simple words, it is used to assess the operations of a company. It began to be used around the mid-1980s by investors who evaluated a company’s potential to pay back the interests and its profitability.
EBITDA is the acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization; these are also called EBITDA components.
Many businesses use this method to analyse their companies’ performance as it offers a clear picture of operations by showing the earnings before the accounting and financial deductions of a company. It depicts the net income, profits, interest, taxes, depreciation, and amortization added back. It ends the effects of financing and capital expenditures and is often used in valuation ratios while comparing to enterprise value and revenue.
Calculating EBITDA means measuring the change in business income while excluding non-business expenses and any non-monetary expenses. The rationale behind this is to eliminate the business owner’s attributes, such as financing, capital structure, depreciation, and (partially) tax methods. It is used to represent a company’s financial performance regardless of its capital structure.
By excluding ITDA factors, EBITDA makes it simpler to analyse the economic state of different companies.
Components of EBITDA
Following are the five main components:
Earnings– Earnings means net profit or merely net income. For example, a company ABC Corporation posts its net earnings for a financial quarter (four-month period) at Rs 1,00,000. In EBITDA, this net income is inclusive of the company’s cost of goods sold, expenses, depreciation and amortization, interest, and taxes.
Taxes– Tax costs vary for different businesses. It often depends on the company industry, position, and size. For example, if ABC Corporation’s taxes amount to Rs 5,000 for the financial quarter, these won’t be deducted from the earnings while calculating EBITDA.
Interest Expense– This expense also varies for different companies; more capital-intensive industries are more likely to have more interest expenses than companies in less capital intensive industries.
For example, if ABC Corporation is a small software company, it will require less capital for carrying out operations than, say, an oil company or a manufacturing company. So, its interest expenses on money raised will be less as well.
Depreciation – It is the reduction in the value of business assets over time, depending on the industry’s various circumstances.
Again, if ABC Corporation is a software company, the depreciation on its assets, which will mainly include computers and software, will be much less than that of an oil drilling or a manufacturing company.
Amortization– This refers to the process of paying off a debt with regular payments, usually in instalments.
For instance, ABC Corporation can fund its operations on much smaller loans, which can be paid rapidly in small instalments compared to a traditionally high capital-intensive company. So, amortization costs will be less for ABC Corporation.
Why Use EBITDA?
The goal of using EBITDA is simple- it helps in quickly understanding a company’s financial health. The use of EBITDA has spread to a vast range of businesses. Its proponents say that EBITDA offers a more straightforward and more transparent overview of operations by excluding expenses that can hinder how the company performs.
EBITDA is widely used to compare companies’ financial conditions and evaluate companies with different tax rates and depreciation strategies. EBITDA is also used as a proxy for a company’s cash flow. The value of a company, its stocks, and operations can be quickly assessed by using EBITDA.
Also, if a company is not posting profits, investors can use EBITDA to evaluate the company’s financial state. Many private companies use this method because it is viable to compare similar companies in the same business.
Why does EBITDA exclude ITDA (Interest, Taxes, Depreciation, and Amortization)?
Interest, which relies heavily on selective financial management, is not taken into account in EBITDA. Taxes are dropped due to their differing nature based on profits and losses; such changes can be detrimental to a company’s income. In essence, EBITDA eliminates inconsistent fines and base penalties included in deductions and payments, such as residual value and other depreciations like machinery deterioration and goods reduction.
By excluding these factors, EBITDA makes it simpler to analyse the economic state of different companies. It is useful in analysing companies with other financial structures, tax, and depreciation policies. EBITDA tells investors how much money a small or reorganized company can make.
By now, it is clear that EBITDA calculates a company’s profitability before reducing the expenses from the net income of a company, such as government taxes, interest to be paid to creditors, depreciation, and interest rates. In reality, these factors are not financial indicators, but they only contribute to calculating the probability of a company’s monetary measures. It tells what the value of a company ‘could have been’ if ITDA weren’t deducted, instead of what the deal is.
As with any other calculation, the bigger the profitability number, the more investors it attracts. Many people have a clear idea of the cost-effectiveness. A large number means that the company has more money after paying all other expenses. However, it is recommended to use it in conjunction with EBIT and EBITA to confirm the business’s actual profit.
Although EBITDA is a widely used performance measurement methodology, its use as a standard measure of income or cash flow can be misleading. In the absence of other considerations, it presents an incomplete and financially risky situation.
Following are the drawbacks of EBITDA:
Cash flow isn’t indicated accurately
Experts believe that using EBITDA as a measure of cash flow is illogical and hazardous. For example, taxation and interest are real cash items that are not optional. A firm that does not pay its government taxes or services its loans is perpetually threatened by the danger of shutting down. And not taking taxes into account while calculating cash flow and profits is impractical.
Contrary to other cash flow metrics, it does not consider the changes in working capital required for day-to-day operations. This is most problematic in fast-growing companies, which require increased investment in receivables and inventory to convert their growth into sales. Those working capital investments consume cash, but EBITDA neglects them.
Changes Interest Coverage
If EBITDA is used, a company can falsely look more profitable to pay off interests.
For example, a business has Rs 10 lakh in operating profits and Rs 15 lakh in interest charges. Suppose the depreciation and amortization expenses worth, let’s say, Rs 8 lakh are added back in the EBITDA metric. In that case, the company suddenly has an EBITDA of Rs 18 lakh capital ability to pay the interests.
But in reality, depreciation and amortization cannot be added back as these expenses are preventable. Even though depreciation and amortization are non-cash entities, they can’t be ignored indefinitely.
Ignores the real value of earnings
Reducing interest payments, taxes, depreciation, and income depreciation may seem easy, but EBITDA uses different income indicators to start for other companies. It is subject to the income statement method included in the income statement. Even considering the differences due to interest rates, taxes, depreciation, and depreciation, EBITDA’s earnings data is unreliable.
EBITDA calculates the profitability of a company in the industry by essentially calculating the company's net income before the numerous tax and other forms of deductions.
Example of EBITDA Calculation
EBITDA is a measure of profits. The usual method for measuring EBITDA begins with operating profit, also called earnings before interest and tax (EBIT). Then depreciation and amortization are added back.
The formula for EBITDA is:
EBITDA = NP + Interest + Taxes + D + A
Where: NP= Net profit, D=Depreciation, A=Amortization
The earnings, tax, and interest numbers are found on the income statement. In contrast, the depreciation and amortization figures are normally found in the notes to operating profit or cash flow statements.
Let’s look at an example and calculate EBITDA for ABC Corporation. The company produces a software and gives digital services like website development. At the end of one financial quarter, it has earned Rs 1,00,000 in total revenues and had the following expenses:
Salaries: Rs 25,000
Office Space Rent: Rs 10,000
Amenities: Rs 4,000
Cost of services and products sold: Rs 35,000
Interest payables: Rs 5,000
Depreciation: Rs 15,000
Taxes to be paid: Rs 3,000
ABC Corporations’ net income at the end of the quarter equals Rs 3,000; its EBITDA is calculated like this:
EBITDA= 3,000 + 5,000 + 3,000 + 15,000 => Rs 26,000.
This means that had the expenses not been deducted from the total earnings, the company would have made Rs 26,000 in earnings.
Although EBITDA is widely used, it is not generally the ideal accounting metric. Therefore, companies and businesses use EBITDA as per their requirements and not as a necessary measure. EBITDA’s problem remains that it cannot provide a complete picture of what the company’s profitability stands at, and therefore investors use it in association with other meaningful methods.
Despite its widespread use, EBITDA isn’t used in generally accepted accounting principles. As a result, businesses can use EBITDA as they wish as it doesn’t give a clear picture of a company’s performance. Usually, investors may be better off avoiding EBITDA or using it in conjunction with other, more meaningful metrics, like Balance Sheet analysis, Working Capital analysis or Profit Statements, among many others.
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