What is EBITDA: Is it the right way to measure a firm’s financial performance

Pranati Deva
Updated: 15 Dec 2021, 12:50 PM IST
TL;DR.

A number of investors and analysts use EBITA to decide whether or not to buy a stock of a firm. However, is that the right way to decide? Let's find out the advantages and disadvantages of using EBITDA for such a decision.

EBITDA measures a firm's performance before external factors like taxes, interest, etc impact the profitability.

EBITDA measures a firm's performance before external factors like taxes, interest, etc impact the profitability.

EBITDA plays a very significant role in understanding a company's financial success. It stands for earnings before interest, taxes, depreciation, and amortization. It measures a firm's performance before external factors like taxes, interest, etc impact the profitability.

It is extensively used to compute the business performance of companies. It is also sometimes used as an alternative to net income.

EBITDA determines the earnings of a firm excluding non-operating factors which the firm does not have any control over. As a result, some experts argue that it is a more accurate way of determining a company's operational profitability and hence should be used more during a financial analysis.

Ignoring tax and interest expenses allows them to focus more on operational performance. Further, depreciation and amortization are non-cash expenses, so EBITDA also provides a clearer insight into the firm's cash flow.

How is it calculated?

To calculate the EBITDA, you add the interest, taxes, depreciation and amortization to the firm's net profit. Another easy way to calculate EBITDA is to take the company’s operating profit, called earnings before interest and tax, and then add its depreciation and amortization values.

EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortization

EBITDA = Operating Income + Depreciation + Amortization

Let's understand the basic terms

- Interest is the expenses a firm incurs due to interest rates.

- Taxes are expenses incurred by a tax imposed by the state and center.

- Depreciation is the non-cash expense incurred on the maintenance of assets.

- Amortization is also a non-cash expense for the intangible assets spread over a long time period. It includes agreements, contracts, patents, and other organisational costs.

A number of times EBITDA is not directly given in the earnings statement but has to be calculated. Earnings, tax, and interest are reported in the company’s earnings report while depreciation and amortizations are given in the cash outflow statement.

Why is it useful

It is generally used to identify if the core business of a firm is doing well and thus is used by many investors to decide whether to invest in a firm or not. It does not take into account the non-applicable expenses and those from intangible assets, so it accounts for only those expenses which are needed for the day-to-day operations of the firm.

It gives a clear picture of how the firm's business is performing on a day-to-day or short-term basis. It also provides a more transparent view of the firm's cash flow. It helps compare two companies efficiently regarding how their operations are doing.

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What is EBITDA

Disadvantages

Since it only focuses on operating profits, some experts criticize it for failing to include capital expenditure. It believes that depreciation or amortization costs can be taken care of later, but that will vary from industry to industry. Tax is also an important and huge expense. Any change in taxation policy will massively impact the company but if an investor is only considering EBITDA, he/she will disregard those effects. Liquidity is needed for daily operations, and not considering tax, interest, etc may not give a very accurate view of the financial condition of the firm.

Also, EBITDA does not fall under GAAP or General Accepted Accounting Principles, so interpreting EBITDA and its components in multiple ways are quite possible. Any small mistake in calculating EBITDA can lead to huge losses as well.

What is EBITDA Margin?

Now that we know what EBITDA is, how do we figure if it is good. It can be done using an EBITDA margin. It is calculated by dividing the total EBITDA by the firm's total revenue and indicates a firm's profitability ratio. This metric is often used by analysts to compare two stocks. A higher margin generally indicates a good potential since it showcases that the operating expenses of a firm are lower than its revenue and vice versa.

Overall, EBITDA is a handy tool for easily comparing and evaluating companies but it cannot be used as a substitute for other metrics like net income. It does provide an efficient way of calculating the core profit of the firm. Nonetheless, the expenses excluded from EBITDA have financial implications and should not be dismissed.

First Published: 15 Dec 2021, 12:50 PM IST
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