Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA)
What is EBITDA?
EBITDA Formula (How to Calculate EBITDA)
To calculate EBITDA, start by reviewing a company’s income statement. EBITDA is not included as a line item on the income statement, but you can calculate it easily by using other items reported on every income statement.
The formula for EBITDA is:
Let's take a look at a hypothetical income statement for Company XYZ:
|Company XYZ's Annual Income Statement|
To calculate EBITDA, we find the line items for Operating Income, or EBT ($350,000), Interest Expense ($50,000), Depreciation ($75,000) and Amortization ($25,000) and then use the formula above:
EBITDA = $350,000 + $50,000 + $75,000 + $25,000 = $500,000
In this example, the firm's EBITDA (i.e. earnings before subtracting non-cash depreciation and amortization expenses, as well as interest expenses and taxes) comes out to $500,000.
Alternate Formula to Find EBITDA
Another easy way to calculate EBITDA is to start with a company's net income, and then add back interest, taxes, depreciation, and amortization.
Here's how that formula looks:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
To find EBITDA using this formula, along with figures from the table above, start with the firm's Net Income ($250,000), then add Interest ($50,000), Taxes ($100,000), Depreciation ($75,000), and Amortization ($25,000).
Here's what the formula would look like:
EBITDA = $250,000 + $50,000 + $100,000 + $75,000 + $25,000 = $500,000
Why EBITDA is So Important
EBITDA is an operating measure commonly used by financial analysts.
Unlike net income, EBIDTA allows 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 as a singular measure of performance. Such analysis is particularly important when comparing similar companies across a single industry, or companies operating in different tax brackets.
EBITDA margin measures a company's earnings before interest, taxes, depreciation, and amortization as a percentage of its total revenue. Because EBITDA is a measure of how much cash came in the door, EBITDA margin is a measure of how much cash profit a company made in a year relative to its total sales.
The formula for EBITDA margin is:
EBITDA Margin = EBITDA / Total Revenue
Using figures from our example table shown above, Company XYZ would have an EBITDA Margin of:
EBITDA Margin = $500,000 / $2,000,000 = 25%
In other words, Company XYZ was able to turn 25% of its revenue into cash profit during the year in this example.
Used as a solvency ratio, the EBITDA coverage ratio measures a company's ability to pay off liabilities such as debts and lease payments. It compares EBITDA and lease payments to the company's total debt payments and lease payments.
The formula for the EBITDA coverage ratio is:
EBITDA Coverage Ratio = (EBITDA + Lease Payments) / (Interest Payments + Principal Payments + Lease Payments)
If a company's EBITDA coverage ratio is equal to or greater than 1, it indicates that the firm is in a better position to pay off its obligations.
All other things being equal, the higher the EBITDA coverage ratio, the better able the company is to repay its liabilities. The lower the EBITDA coverage ratio, the harder it will be for a company to repay its obligations.
Why did famous billionaire investors Warren Buffett and Charlie Munger at one point in time refer to EBITDA as "BS Earnings"?
EBITDA is a valuable measure of company profitability, but it also has its drawbacks.
For starters, it can be trumpeted by companies with low net income in an effort to "window-dress" their profitability, as EBITDA will almost always be higher than reported net income.
EBITDA can also be deceptive when applied to certain types of companies, such as telecommunications firms. It is especially unsuitable for firms (like telecoms) that are saddled with high debt loads or those that must frequently upgrade costly equipment. For companies in those situations, interest payments and depreciation (resulting from significant capital expenditures) represent a recurring drag on annual cash flows, and they deserve to be counted as "real" expenses.
In addition, because EBITDA isn't regulated by GAAP, investors are at the discretion of the company to decide what is, and is not, included in the 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.
Therefore, when analyzing a firm's EBITDA, it is best to do so in conjunction with other factors such as capital expenditures, changes in working capital requirements, debt payments, and, of course, net income.
Can a company post negative EBITDA during a given quarter or year?
Absolutely. If a company's losses are significant enough, then yes, it is possible for a firm to post negative EBITDA.
Let's say a company's net income was negative $1 million for the year. If the firm's annual interest expense, taxes, depreciation, and amortization came out to less than $1 million combined, then the company would have a negative EBITDA after those expenses were added back to the company's earnings (or in this case, losses).
I noticed that "amortization" is included in the definition of EBITDA. What is amortization? Can you run through an example of amortization?
Amortization is an accounting term that refers to the process of allocating the cost of an intangible asset over a period of time.
For example, let's assume Company XYZ owns the patent on a piece of technology, and that patent lasts 15 years. If the company spent $15 million to develop the technology, then it might record $1 million in amortization each year for 15 years as an expense on its income statement.
What other financial measures are similar to EBITDA?
Where can I learn more about EBITDA? Can you provide some examples of how EBITDA is used in investing?
For more great information and examples of how you can use EBITDA, check out these articles from InvestingAnswers:
The Best Alternative to the Flawed P/E Ratio
Shows how EBITDA can be used along with enterprise value (EV) to measure a company's valuation relative to its peers.
The LBO Value Equation
Shows how investment firms use EBITDA and other variables to value a potential acquisition target.