Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA)
What Is EBITDA?
Earnings before interest, tax, depreciation, and amortization (EBITDA) is a measure of a company's operating performance. It's a way to evaluate a company's performance without having to factor in financing/accounting decisions or tax environments.
Let’s break down the EBITDA acronym into its components:
Earnings - Income
Before - Excluding the following items from the metric:
Interest - because this depends on the financing structure of a company
Taxes - because this depends on the geographic location of a company
Depreciation and Amortization - because this depends on past investments, not current operating performance
EBITDA provides a metric for operating profit that excludes the effects of expenses that aren’t directly related to operations. While this is helpful for comparing the profit of companies, it has limitations:
EBITDA can be used by companies with low net income to try and "window-dress" their profitability. EBITDA will almost always be higher than reported net income, making it a figure that can skew an investor’s perspective (if they are not also looking at the bottom line).
EBITDA can be deceptive when applied to certain types of companies. Any firms that are saddled with high debt loads (or those that must frequently upgrade costly equipment) should not use EBITDA as a metric. For companies in these situations, interest payments and depreciation represent a recurring drag on annual cash flows. This deserves to be counted as "real" expenses.
EBITDA calculations do not adhere to generally accepted accounting principles (GAAP). Investors are at the discretion of the company to decide what is – and is not – included in the EBITDA calculation. There's also the possibility that a company may choose to include different items in their calculation from one reporting period to the next.
That said, EBITDA is a primary tool for analyzing a company’s ability to make a profit from sales. This figure can then be compared across companies and industries. EBITDA should not be used as the sole metric for examining a company’s financial health and should be used in conjunction with other metrics (e.g. net income, debt payments).
What Is the EBITDA Formula?
EBITDA is calculated by adding back the non-cash expenses of depreciation and amortization to a company's operating income:
How to Calculate EBITDA
Let’s calculate EBITDA using Company XYZ’s hypothetical income statement below.
To calculate EBITDA, find the line items for:
- Operating Income, or EBT ($350,000)
- Interest Expense ($50,000)
- Depreciation ($75,000) and
- Amortization ($25,000)
Then, plug those numbers into the EBITDA formula.
In this example, the firm's EBITDA (i.e. earnings before subtracting non-cash depreciation and amortization expenses, interest expenses, and taxes) comes out to $500,000.
Alternate Formula for EBITDA
Another easy way to calculate EBITDA is to start with a company's net income and add back interest, taxes, depreciation, and amortization.
Here's how that formula looks:
To find EBITDA using this formula – and the income statement above – find the line items for:
Net Income ($250,000)
Depreciation ($75,000), and
Here's what the formula would look like:
What is EBITDA Margin?
EBITDA is a measure of operating profit. EBITDA margin, however, is a measure of how much cash profit a company made in a year, relative to its total sales. EBITDA margin measures a company's earnings before interest, taxes, depreciation, and amortization as a percentage of its total revenue.
Formula for EBITDA Margin
Using figures from our example Income Statement for Company XYZ above, the EBITDA Margin would be:
The margin tells you that Company XYZ was able to turn 25% of its revenue into cash profit during the year.
What Is the EBITDA Coverage Ratio?
The EBITDA coverage ratio measures a company's ability to pay off liabilities such as debts and lease payments. It is a solvency ratio, meaning that it compares EBITDA and lease payments to the total debt payments and lease payments.
EBITDA Coverage Ratio Formula
The higher the EBITDA coverage ratio, the better able a company is to repay its liabilities. In general, if a company's EBITDA coverage ratio is at least equal to 1, it means that a company is in a good position to pay off its debts. The lower the EBITDA coverage ratio, the harder it will be for a company to repay its obligations.
What Is the EBITDA Multiple?
EBITDA Multiple (also referred to as Enterprise Multiple) is a ratio that compares a company’s total market value (Enterprise Value) to EBITDA. This metric is used to determine whether a company is over or undervalued.
1. Find Enterprise Value
To determine the EBITDA multiple, you must first find the company's enterprise value.
The enterprise value is calculated thusly:
2. Use EV and EBITDA to Derive Enterprise Multiple
Once you know the company's enterprise value, simply divide by the company's EBITDA.
A company with a low enterprise multiple is considered to be an attractive investment because it reflects a low price for the value of the company. This simply means more company for your dollar.
The History of EBITDA
EBITDA gained popularity in the 1980’s when leveraged buyout investors were looking at restructuring companies that were going under. EBITDA was used to determine whether companies could pay their liabilities and take on new debts for company restructuring.
While EBITDA was popular at the start for a quick look at a company's ability to handle restructuring, EBITDA is still used by analysts to focus on the outcome of operating decisions, while excluding the impacts of non-operating decisions like:
interest expenses (a financing decision)
tax rates (a governmental decision), or
large non-cash items like depreciation and amortization (an accounting decision)
By minimizing the non-operating effects that are unique to each company, EBITDA allows investors to focus on operating profitability. This singular measure of performance is particularly important when comparing similar companies across a single industry – or companies operating in different tax brackets.