EBITDA

What is EBITDA?

The full name for EBITDA is known as earnings before interest, tax, depreciation, and amortization. For beginners, this looks like a complicated and unnecessary term. People may even ask, "How does an earning before a bunch of things matter?" The answer is: EBITDA is an essential metric in accounting, and here are the reasons.

Long words short, EBITDA is a more precise metric for investors who purely wants to investigate a company's operating performance. EBITDA is the earning that excludes all the influences of financial and accounting deductions, including tax, interest, depreciation, and amortization (which, seem complicated but are all names for financial and accounting approaches).

EBITDA Calculation

Here are some ways of calculating EBITDA:

EBITDA = Net Income - Interest - Tax - Depreciation - Amortization

Or:

EBITDA = EBIT (Operating Income) + Amortization + Depreciation

Note: Amortization and depreciation are usually found under the accountant notes or in the cash flow statement.

To learn more about depreciation and amortization, view the following articles:

1. Depreciation
2. Amortization

Application Scenario

EBITDA is useful because it normalized a company’s business to make it more straightforward for valuations. Here are some scenarios in that EBITDA becomes handy to measure a company's profitability:

1. Comparing companies under the same industry but with different tax structures. Simply using net profit to indicate the companies' profitability is overgeneralizing the case. By using EBITDA, it cuts tax out of from affecting the analysis.

2. Investing companies within capital-intensive industries. Some examples could be the real estate, manufacturing, and oil industries. These industries all have heavy proportions and fix assets (PP&E). In common, they take lots of debt. This caused the companies to charge a lot of interest each year. When the investor purely wants to compare the earning ability of two companies, it is a smart decision to get rid of the effect of interest.

3. When a company owns a huge proportion of fixed assets, depreciation and amortization are playing essential roles in accounting for these assets. Simply speaking, since there is a limited lifetime for each fixed capital, companies often tend to split the cost of the fixed capital into multiple years. However, if an investor only wants to learn the profitability, then it is a good choice to not let depreciation and amortization affect the calculation.

4. Compare companies with different capital structures. Imagine two companies selling balloons. Although the balloons from both companies are pretty and colorful, Company A had $100 more in net profit compared with Company B. After calculating the EBITDA, an investor found out that the EBITDA for both companies are the same! Further investigation explained this result. Company A relies primarily on equity for funds, whereas Company B relies more heavily on debts. The additional interest paid on debts caused Company B’s net profit to be less than Company A. Therefore, comparing EBITDA with net profit can reveal investors and business managers more details when examining the income statement.