EBITDA
Encyclopedia
EBITDA iː is an 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.
s. 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.
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
.
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.
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.
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:
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 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.
Profit (accounting)
In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...
before interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
, taxes, depreciation
Depreciation
Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
, and amortization
Amortization (business)
In business, amortization refers to spreading payments over multiple periods. The term is used for two separate processes: amortization of loans and amortization of intangible assets.-Amortization of loans:...
. It is a non-GAAP
Generally Accepted Accounting Principles
Generally Accepted Accounting Principles refer to the standard framework of guidelines for financial accounting used in any given jurisdiction; generally known as accounting standards...
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
Cash flow statement
In financial accounting, a cash flow statement, also known as statement of cash flows or funds flow statement, is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing...
primarily by excluding payments for taxes or interest as well as changes in working capital
Working capital
Working capital is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is...
. EBITDA also differs from free cash flow
Free cash flow
In corporate finance, free cash flow is cash flow available for distribution among all the securities holders of an organization. They include equity holders, debt holders, preferred stock holders, convertible security holders, and so on....
because it excludes cash requirements for replacing capital assets
Capital asset
The term capital asset has three unrelated technical definitions, and is also used in a variety of non-technical ways.*In financial economics, it refers to any asset used to make money, as opposed to assets used for personal enjoyment or consumption...
(capex
CAPEX
CAPEX, also known as the Kerala State Cashew Workers Apex Industrial Co-operative Society, is an organization managed by the government of Kerala to promote the cashew industry and especially the export market for cashews.-Organization:...
).
EBITDA margin refers to EBITDA divided by total revenue. EBITDA margin measures the extent to which cash operating expenses use up revenue.
Use by debtholders
EBITDA is widely used in loan covenantLoan covenant
A loan covenant is a condition in a commercial loan or bond issue that requires the borrower to fulfill certain conditions or which forbids the borrower from undertaking certain actions, or which possibly restricts certain activities to circumstances when other conditions are met.Typically,...
s. 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.
- 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.
- 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
Free cash flow
In corporate finance, free cash flow is cash flow available for distribution among all the securities holders of an organization. They include equity holders, debt holders, preferred stock holders, convertible security holders, and so on....
.
Use by shareholders
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.It is true that PE can use this metric. And it is true the professional analysts using detailed discounted cash flow
Discounted cash flow
In finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money...
models should replace non-cash expenses with projected time-weighted payments. But none of that applies to retail investors' reality.
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.
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
Warren Buffett
Warren Edward Buffett is an American business magnate, investor, and philanthropist. He is widely regarded as one of the most successful investors in the world. Often introduced as "legendary investor, Warren Buffett", he is the primary shareholder, chairman and CEO of Berkshire Hathaway. He is...
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:
- the allocation of the original cost, at a later date, when the asset was used to generate revenue. The time value of moneyTime value of moneyThe time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. The time value of money is the central concept in finance theory....
(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 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.
- 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.
Non-profitable businesses
When comparing businesses with non 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.
During the dot com bubble companies promoted their stock by emphasising either EBITDA or pro forma
Pro forma
The term pro forma is a term applied to practices or documents that are done as a pure formality, perfunctory, or seek to satisfy the minimum requirements or to conform to a convention or doctrine...
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
Gaap
In demonology, Gaap is a mighty Prince and Great President of Hell, commanding sixty-six legions of demons. He is, according to The Lesser Key of Solomon, the king and prince of the southern region of Hell and Earth, and according to the Pseudomonarchia Daemonum the king of the western region and...
, 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 CostsEarnings Before Interest, Taxes, Depreciation, Amortization, and Restructuring or Rent CostsEarnings Before Interest, Taxes, Depreciation, Amortization, and Restructuring or Rent Costs is a non-GAAP metric that can be used to evaluate a company's financial Performance....
(EBITDAR) - RevenueRevenueIn business, revenue is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. In many countries, such as the United Kingdom, revenue is referred to as turnover....
- Gross profitGross profitIn accounting, gross profit or sales profit is the difference between revenue and the cost of making a product or providing a service, before deducting overhead, payroll, taxation, and interest payments...
- Earnings before interest and taxesEarnings before interest and taxesIn accounting and finance, earnings before interest and taxes is a measure of a firm's profit that excludes interest and income tax expenses. Operating income is the difference between operating revenues and operating expenses...
(EBIT), or operating profit - Net profitNet profitNet profit or net revenue is a measure of the profitability of a venture after accounting for all costs. In a survey of nearly 200 senior marketing managers, 91 percent responded that they found the "net profit" metric very useful...
or Net incomeNet incomeNet income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings... - EV/EBITDAEV/EBITDAEV/EBITDA is a valuation multiple used in finance and investment to measure the value of a company. This important multiple is often used in conjunction with, or as an alternative to, the P/E ratio to determine the fair market value of a company.An advantage of this multiple is that it is capital...
- P/E ratioP/E ratioThe P/E ratio of a stock is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share...
- OIBDAOIBDAOIBDA is an acronym meaning operating income before depreciation and amortization. It refers to an income calculation made by adding depreciation and amortization to operating income....
- Operating marginOperating marginIn business, operating margin — also known as operating income margin, operating profit margin and return on sales — is the ratio of operating income divided by net sales, usually presented in percent....