Earnings Before Interest, Taxes, Depreciation and Amortization – EBITDA

Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is an approximate measure of a company’s operating cash flow based on data from the company’s income statement. It is calculated as follows by looking at earnings before the deduction of interest expenses, taxes, depreciation, and amortization:

      EBITDA = Revenue – Expenses (excluding tax, interest, depreciation and amortization)

It allows investors to see how much money a company is making before taxes, depreciation and amortization have been deducted. Basically, when investors place money in a company, they will want to know how much money the company has been making since their money was invested. EBITDA gives the investor an idea of how much money the company has made before its deductions. It is especially useful for a new company who has just started business and has not yet been hit with taxes, payments to creditors, and so on.

This earnings measure is of particular interest in cases where companies have large amounts of fixed assets which are subject to heavy depreciation charges (such as manufacturing companies) or in the case where a company has a large amount of acquired intangible assets on its books and is thus subject to large amortization charges, such as a company that has purchased a brand or a company that has recently made a large acquisition. Since the distortionary accounting and financing effects on company earnings do not factor into EBITDA, it is a good way of comparing companies within and across industries.

This measure is also of interest to a company’s creditors, since EBITDA is essentially the income that a company has free for interest payments.

EBITDA has two main uses:

(1) As a comparison over time of the profitability of a company’s operations without the potentially distorting effects of changes in depreciation, amortisation, interest and tax.

(2) To calculate EV/EBITDA, a valuation ratio free of these distortions, allowing fair comparisons of companies with different capital structures.

EV/EBITDA (Enterprise Value/Earnings Before Interest, Taxes, Depreciation and Amortization ) is one of the most widely used valuation ratios. It is:

      EV ÷ EBITDA

The main advantage of EV/EBITDA over the P/E ratio is that it is unaffected by a company’s capital structure. It compares the value of a business, free of debt, to earnings before interest.

Interest and tax are excluded because they include the effect of factors other than the profitability of operations. Interest is a result of the company’s financial structure. Depreciation and amortisation (and depletion, when it appears) reflect the accounting treatment of past purchases and are unrelated to future cash flows, and future cash flows are what ultimately matter to investors.

EBITDA can also be regarded as a measure of underlying cashflow. It is closely related to operating cash flow. The difference is that operating cash flow includes the effects of changes in working capital). EBITDA can therefore be used as a measure of underlying cash flow (i.e. stripping out the volatile effects of changes in working capital).

If the EBITDA figure seems to have a good growth rate, then some investors may use this figure instead of the overall net figure. It can show them that the company has a future for potential growth and that they will get a return on their investment. Investors call this looking at the EBITDA margin rather than the net margin.

There are potential problems in using the EDITDA figure. The EBITDA leaves out of lot of expenses in the final figure, so it may not be a realistic view of a company’s profitability. It also does not measure the actual cash that is flowing into the company because of the figures that it leaves out.

There are a few factors that the EBITDA neglects. These include the money required for working capital, fixed expenses and other debt payments and capital expenditures. In every business, capital expenditures are a crucial, ongoing expense. However, this is not factored into the EBITDA figure, so investors need to be wary when using the EBITDA figure as a basis for a profit margin.

EBITDA margin

EBITDA margin is a financial metric used to assess a company’s profitability by comparing its revenue with earnings. More specifically, since EBITDA is derived from revenue, this metric would indicate the percentage of a company is remaining after operating expenses. It is equal to EBITDA divided by total revenue. EBITDA margin measures the extent to which cash operating expenses use up revenue.

For example, if XYZ Corp’s EBITDA is $1 billion and its revenue is $10 billion, then its EBITDA margin is 10%. Generally, a higher value is appreciated for this ratio as that would indicate that the company is able to keep its earnings at a good level via efficient processes that have kept certain expenses low.

However, when comparing company’s EBITDA margin, make sure that the companies are in related industries as different size companies in different industries are bound to have different cost structures, which could make comparisons irrelevant.

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