The term EBITDA is a very common accounting term used in every commercial organization. It stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is used as an alternative to denote several metrics like revenue, profits or the total earning of any business concern.
In this article, you will learn what EBITDA means in details and how to apply it.
What is the meaning of EBITDA?
EBITDA is a measure of accounting that is used to find out the total earning of a particular business before paying off the interests, taxes, depreciation charge and amortization value. This term is used to determine how much profit that particular business has made with respect to its present valuables and all the products produced and sold by it. It also provides an alternative for the cash flow of that concern.
EBITDA shows the overall performance of the company. It helps to calculate the value of the business by focusing on the economic outcomes from the various operating decisions. EBITDA removes the effects of the non-operating decisions that are taken by the present management level officials. This includes value of interest, tax rates, or other notable abstract assets.
The EBITDA of any company shows its operating profitability much better. This figure can be very helpful in deciding the credibility of any business. It helps every investor and buyer to choose that particular company that can be more lucrative and profitable.
But calculation of EBITDA can also be misleading at times. It does not display the cost of the various financial investments like property, plant, and any machinery used. This accounting measure also does not include expenses that are related to the debt as the interests and the taxes are added to the earnings.
Despite the shortcomings, EBITDA still makes for a great accounting measure for every business performances as it can display the earnings before it goes through the effect of accounting and deductions related to finance.
No company is under any legal pressure for disclosing its EBITDA in any public forum. However, EBITDA can be accounted for by calculating the data displayed in the financial report of the company. Any company has its earnings, taxes, and interest amounts displayed on its financial statement. The figures for depreciation and amortization can be easily calculated from its statement of cash flow.
EBITDA can be easily calculated by beginning with the organization’s profit and then adding to it every value of depreciation and amortization. This value will give a perfect representation of the company’s operating profit and help every investor and buyers in choosing the best in the business who can be easily trusted.
How is EBITDA calculated?
There is a particular formula that is employed for calculating EBITDA. It goes by:
EBITDA = Total Earning + Interest + Taxes + Depreciation + Amortization
It can also be represented as:
EBITDA = Total operating profit of any organization + Depreciation + Amortization
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Interest is deducted from EBITDA value because it is totally dependent on a company’s economic framework. It comes along with the capital that has been borrowed as a fund for operating the various business functions. Every company has its own economic structure. Therefore its rate of interest also differs from that of others. Thus it is much easier to compare two different companies in terms of their relative profitability.
This can be done by adding its rate of interest and leaving aside every effect of the financial structure on that business. Interest values that are paid are subjected to deduction of taxes. Any business concern can take this advantage which is termed as corporate tax shielding.
Taxes levied on any company entirely depend on that particular area which is the operating place for its business. Therefore axes can be concluded as a varying attribute. Taxes are considered as those expenses that any company is obliged to pay to the government concerned in the jurisdiction of its operation.
These values of taxes have nothing to do with the company’s performance. They are a must to be paid variable that cannot be ignored at any cost. This is why many financial analysts add its value to the total earning of that business while drawing a comparison. For all Taxes relevant queries, you can take a tax homework assistance online.
Values of depreciation and amortization entirely depend upon all those investments that the company made in its past. It has nothing to do with that company’s present business operations. Every company makes investments in several assets that are meant to stay for long terms. For example properties and automobiles come under this category of long term assets.
These assets will lose their values due to constant usage. Therefore the depreciation cost of any company depends upon the deterioration of its abstract assets.
Amortization is processed if the company’s assets are intangible. For example patents of any company come under this category. They have a limited life and will surely expire with time.
Values for depreciation and amortization can be easily found out from that particular company’s cash flow statements. They are displayed under the section of cash from operating activities. As these two values are completely non-cash expenses of the company, the financial analysts prefer to add it back in the cash flow statements.
Uses of EBITDA
EBITDA is surely not a definite financial measure recognized as a sure accounting method. But this figure is used in many financial areas while the performance of any company is evaluated. For example, investors use this figure to analyze the security of investing in a particular company. They can compare the profitable performances of various companies by comparing their EBITDA values.
This can be done by ignoring the effects of interest values from the financial statements, taxes paid to its local governing body, total assets present with it, and takeovers by various managements. EBITDA is very useful as it can give a measurement of cash flow from various business operations that are used in mergers and acquisitions of small business bodies.
The calculation of EBITDA must be done accurately and genuinely as it plays a very important factor in comparing one business from the other in terms of overall performance.
Any EBITDA value that displays a negative number determines that the business is having a serious issue with its profitability and cash flow management. Whereas an EBITDA value displaying a positive number may not always depict that the business is able to generate a good amount of cash. As EBITDA looks over the alterations in current working capital, expenses, taxes, and interests, so its value is not the obvious one to determine the generation of cash within a business.
An EBITDA value can be used to evaluate and compare overall profitable performance amongst different companies. This EBITDA figure can also be useful in comparing the value of the business and its revenue.
Cost of interest and income of interest are added to the total income of any business. This neutralizes the debt value and also any effect that interest values have on payable taxes. Income taxes are also added to the value of total income of that business. But this does not increase the EBITDA figure if that company is facing net loss.
Most of the companies highlight their EBITDA value when they do not have a great overall income. Sometimes they even show it if they are having a negative EBITDA value. They do it to distract the investors as they might otherwise be able to locate that company’s inefficient profit or sometimes complete loss.
Many companies utilize their accounts of depreciation and amortization to pay the expense of their property, plants, and machinery involved. This can also be termed as capital investments of the company. Amortization accounts are also often used to pay the money for software developments needed in that company or for other intellectual properties.
Those companies which are very new in the business tend to feature their EBITDA in their company’s profile. They do it while meeting investors and analysts to attract their attention and leave a positive impact on them.
Any management team believes that using EBITDA will give a better picture of the scenario related to that company’s growth in terms of profit if all expense accounts related to finance are separated from its value. EBITDA is surely not a misleading measure to show how any company has grown profitably. But sometimes it can conceal any business’ exact financial performance and any risk related to it.
If any company is not making a profit for a longer period of time, then investors can take help of their EBITDA figure to evaluate that company’s overall performance. Many privately held equity firms refer to this metric as it proves a useful means while comparing similar kind of companies in the same category. A business owner can also use EBITDA value of his own business to establish a successful comparison between his business and that of his contemporaries.
Disadvantages of EBITDA
EBITDA is not considered under Generally Accepted Accounting Principles (GAAP) as an obvious value to show the financial performance of any company. Because of this, its evaluation varies amongst different companies.
Most of the companies put a lot of importance in displaying their EBITDA value over other statements that show the total income of that company. This is because EBITDA is a more flexible value that can conceal all those problematic areas in any financial statement of a company.
The investors start to take notice of this trick when they find that a company is emphasizing on its EBITDA report more than it usually did in the past. This is when they tend to find out that the company must be suffering from losses of late. And that is compelling them to take the help of their EBITDA report to escape unwanted situations.
Some of the drawbacks of using EBITDA
EBITDA has got some major drawbacks which prevent it from becoming an obvious value. Firstly, it does not take into account the cost of assets of any company. EBITDA completely ignores the expense related to assets. This can be very misleading as the profit of any business is not only related to its sales and performances. The assets maintained by the companies should surely be taken under consideration as they account for a good amount of liability.
Secondly, EBITDA does not consider working capital needed in any business. It tends to ignore the capital that is needed for the operation of any business and to replace and maintain its old machinery. There is a big chain of events that are involved in the whole process of production. Each and every event incurs some cost. All these costs must be surely taken into account to make a fair calculation of the total profitability of any business.
Thirdly, EBITDA can reduce the exact value of any company. This is surely a major drawback of EBITDA. When financial analysts consider the share value of EBITDA over its exact earning then this blunder takes place. The company looks much less expensive than its real worth.
Points to be noted
- EBITDA can be a very useful metric to calculate the overall profitability of any business
- It can be employed in the comparison process between two competitors
- EBITDA report is very helpful in finding out industry averages
- It can help in measuring the actual profit pattern of and company
- EBITDA can easily work as a shortcut method to evaluate the flow of cash within a business that will be required to pay off the expense of assets
EBITDA is an important thing to learn as it has got much usefulness. If you like to sell your business then it is very important to have a good knowledge of EBITDA as it will help you to get potential buyers.
The author of this article, Nancie L Beckett is a fantastic online tutor. She has completed her MBA degree years ago from the Harvard Business School. After acquiring her MBA degree she started working with a world-famous Accountancy firm that is headquartered in Michigan. She has worked on numerous assignments and can help you in solving your doubts in Accounting, Finance, Marketing, and Management. Click here to read here blogs.