There’s an old saying in the investment community, “Figures lie and liars figure.” It was a reminder that you needed to understand what you were looking at, but that all of the truth of a business is not found in the numbers. That caution can be very relevant when looking at EBITDA.
What is EBITDA?
EBITDA stands for earnings before interest taxes depreciation and amortization. So, what does that mean? In short, EBITDA measures profits. While a company is not legally required to report EBITDA, investors work it out from financial statements. It can be useful when comparing companies or industries for profitability. However, it can be misleading to rely too heavily on this single metric.
How to Calculate EBITDA
The income statement provides the earnings, tax, and interest numbers. In order to find the depreciation and amortization figures, it’s necessary to look in the operating profit notes or the cash flow statement. The shortcut method for calculating EBITDA is to begin with the “earnings before interest and tax,” or EBIT, and then add depreciation and amortization back into the equation. Is this Everything you Need to Know about EBITDA? No.
The Rationale for EBITDA
In the mid-1980s, there was a frenzy of leveraged buyouts. Investors would examine a company in distress using EBITDA as a quick measurement for whether or not the company would be able to pay back the interest.
When looking at EBITDA Everything you Need to Know, proponents argue that it’s easier to get a quick snapshot of the company by removing expenses that obscure how a company is actually performing. Those who say to use caution argue that the usefulness of EBITDA depends on the individual business structure.
The rationale for removing these expenses is as follows:
- Interest is ignored because it can vary depending upon how management chooses to obtain financing;
- Taxes are stripped because acquisitions and prior year losses can have a significant affect upon taxes;
- Depreciation and amortization are taken out because they are subjective judgments and can vary depending upon the depreciation method used, for example.
The earnings figure left after removing these items makes it easier to compare companies with different capital structures, tax rates, or that use different depreciation methods. It indicates how much money the company would have to make in order to pay creditors or taxes. A highly leveraged company will look better using an EBITDA calculation than if one looks only at operating profits.
Reasons for Caution
- EBITDA is not a useful measurement of cash flow. Interest and taxes are paid with hard cash. Working capital is needed to cover daily expenses. EBITDA also ignores capital expenditures, which can be substantial. When those items that use real, hard cash are ignored, this actually overstates cash flow.
- EBITDA can make it appear that a company can make interest payments more easily than it actually can. Also, depreciation and amortization, while subjective balance sheet items, represent real conditions. At some point, money will be needed for equipment repairs and replacements.
- EBITDA ignores the quality of a company’s earnings. Accounting games (“figures lie”) can skew the earnings figure.
- EBITDA can be used to make a business appear less expensive than it actually is. Looking at EBITDA stock price multiples rather than the bottom line earnings can produce a lower multiple.
While EBITDA is widely used, it isn’t defined in GAAP, allowing companies to report it however they wish. It doesn’t give a complete picture of how the company is performing. Instead of relying upon EBITDA, research the company more thoroughly and use more meaningful metrics.