EBITDA is an acronym that stands for earnings before interest, taxes, depreciation (the decline of an assets value over time), and amortisation (the gradual writing off of an asset's value over a specific time period via accounting). This metric provides a quick and straightforward picture of a company’s current profitability. Earnings are looked at before taxes, depreciation, interest or amortisation are taken into account.

EBITDA can be used to determine a company’s financial health and is a beneficial reference point for investors looking for a long-term return on investment.

How is EBITDA calculated?

EBITDA can be determined using two different calculations. 
  1. You can add amortisation and depreciation to a firm’s operating income.
  2. You can add amortisation, depreciation, interest and tax to a firm’s net income.

Example calculations for EBITDA

If Company A had earnings of EUR 5 million, operating expenses of EUR 1 million, and amortisation and depreciation totalling EUR 250,000, its earnings before interest and taxation (EBIT) would be EUR 3.75 million. If Company A’s interest totalled EUR 200,000, its pre-tax earnings would be EUR 3.55 million. If its annual taxes totalled EUR 400,000, its net income is EUR 3.15 million.

From these numbers, we can start with the operating income of EUR 3.75 million (note that in some cases, EBIT and operating income can differ, but they’re equivalent in our example). Add back amortisation and depreciation for an EBITDA of EUR4 million.

To use the second calculation instead, we would take the net income of EUR 3.15 million and add back taxes (EUR 400,000), interest (EUR 200,000), and amortisation and depreciation (EUR 250,000) for an EBITDA of EUR 4 million.

What’s the difference between EBITDA and operating cash flow?

EBITDA and operating cash flow are often mistaken for one another when reporting a company’s revenue. People often use the EBITDA value when talking about a company’s cash flow, but there are several differences between the two.

In broad terms, operating cash flow represents the money flowing in and out of a company. Operating cash flow is determined by combining depreciation and amortisation with net income while factoring in any adjustments within accounts payable and receivable.

While EBITDA also adds depreciation and amortisation back into its final calculations, it doesn’t take taxes or interest into the equation. These are essential for operating cash flow as they are considered cash outflows.

Both EBITDA and operating cash flow are popular metrics for gauging how effective a company is at generating income through its primary services. It’s important to know what is included in the figure you are reviewing to ensure you make informed judgements when analysing a company. 

History and importance of EBITDA

EBITDA was first used by an entrepreneur named John C. Malone. A former CEO and president of Tele-Communications Inc., Malone honed this business metric to show the cash-generating potential of telecommunications firms.

Malone believed the best way of optimising the earnings per share of his company for shareholders flew in the face of his telecoms company’s ambition to scale. In Malone’s view, bigger net incomes led to greater taxation. Instead, he sought to minimise reported earnings and taxes, allowing his company to invest in growth and engage in mergers and acquisitions using pre-tax cash flows.

Hence, the metric of EBITDA was born: a “pure” income figure for a business to highlight its cash-generating potential.

Pros and cons of EBITDA

What are some of the advantages and disadvantages of using EBITDA to determine the value and potential of businesses you’re thinking of investing in?

Pros of EBITDA

  • Compares profitability of companies
    If you’re analysing companies to invest in, EBITDA is good for comparing the revenue generation between similar companies. This is because it’s a simple metric of overall performance that does not take uncertain/subjective calculations of amortisation and depreciation into account.
  • Offers a neutral approach to capital structure
    EBITDA is known as a “capital-neutral” metric. That’s because it doesn’t factor in capital investment and other debt financing variables, and instead attempts to show a company’s profits generated by operations.
  • Indicates whether there is a sound business model
    Those who value the EBITDA metric say that it provides a fair overview of a business’ performance and whether its business model is profitable and scalable. It focuses squarely on a company’s revenue-generating capabilities.
  • Factors in only critical day-to-day expenses
    EBITDA only accounts for essential everyday operating expenses for a business, helping to keep this metric as top-line as possible.

Cons of EBITDA

  • Provides no consideration for changes in working capital
    One of the biggest drawbacks of EBITDA is that it overlooks the fluctuations in a company’s working capital. A business’ liquidity can change for many reasons, be it tax bills, interest or capital expenditure.
  • Doesn’t reveal high interest rates on debt repayments
    As interest is added back onto a company’s earnings, it's challenging to get a handle on a business’ indebtedness when looking only at EBITDA. Some businesses may use EBITDA to cloak the fact that they have a considerable debt burden or debt at rising interest rates.
  • Considered a “window dressing” of company accounts by some critics
    Sticking with the “cloaking” angle, critics of EBITDA believe it can also be used in a disingenuous manner. By excluding debts, some say that EBITDA is a form of façade, which improves the surface-level appearance of a company’s financial statements to attract investors—some of whom may not dig deeper into the figures before investing.

What does EBITDA mean for traders and their portfolios?

Day traders may get little out of using EBITDA as a metric in their analysis, but those who prefer longer-term swing trades will keep a close eye on a company’s EBITDA to see A) if it’s growing and B) the rate of growth year-over-year. Investors looking for stocks with long-term growth potential should seek companies with consistent and considerable EBITDA growth when building their portfolios.

Some investors will also look at the enterprise value (EV) of a company compared to its EBITDA to determine if a stock is undervalued. EV/EBITDA is displayed as a valuation multiple to define a fair market price for a company. Historically speaking, companies with EV/EBITDA multiples of less than ten are attractive to value-seekers.

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