EBITDA is an acronym for Earnings Before Interest, Tax, Depreciation and Amortization. It is one of a number of ways of measuring a company’s current operating performance. In other words, how much profit is being made with the current asset base and on the products it produces and sells. In certain circumstance, the figure can be interpreted as a proxy for cash flow or used as an alternative to simple earnings or net income. EBITDA helps simplify comparisons between different companies and evaluate the performance of a firm by removing the need to include financing decisions and accounting deductions or variable tax regimes.
If a target firm is sold and delivered to the buyer free of debt, the difference in how the acquirer finances, and how the target previously financed its business, is no longer relevant. Following the acquisition, the acquirer is now free to select a financing option which is most beneficial to the enlarged group. In this instance, using EBITDA as an earnings metric is commonplace in buyouts by private equity firms or in strategic mergers and acquisitions. It is assumed that a new owner will have the ability to change the composition of the balance sheet.
However, EBITDA can be misleading as it removes the cost of capital investments like property, plant, and equipment (PPE). As interest expenses and taxes on earnings are added back, the figure excludes the expenses associated with debt.
Note: Although it is often shown on an income statement, EBITDA it is NOT considered part of the Generally Accepted Accounting Principles (GAAP) by the SEC.
EBITDA Example
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
EBITDA = Operating Profit + Depreciation expense + Amortization expense
Investors should watch when a company starts reporting this figure prominently when it has not done so in the past. If the company has borrowed heavily and the cost of capital is increasing, EBITDA can serve as a distraction and may be misleading. Other criticisms of the calculation are as follows,
- Ignores Costs of Assets
- Ignores Working Capital
- Varying Starting Points
It is important traders are aware of these issues and are able to interpret the effects on the results especially when EBITDA is incorporated into any precedent transaction analysis calculations used in M&A.
