Ah, EBITDA (pronounced EBIT-DAH).
Investment Bankers and Private Equity Shops roll it off their tongues. Yet, there is something elusive about this non-GAAP metric that has the novice investor going, “…what?”.
Let’s dive in:
EBITDA stands for earnings before interest, taxes, depreciation, and amortization***. Simply put, it’s the value of a company’s bottom line before interest, taxes, depreciation, and amortization are taken out from the income statement.
A more visual explanation looks like: EBITDA = Net Income + Interest + Taxes + Depreciation + (Amortization)
I like to think of EBITDA as a measure of a company’s core financial earnings and its ability to service long-term debt. It’s also a way of making a more apples-to-apples comparison for firms in the same sector.
Here’s an example:
There is Company A and Company B, both operate in the restaurant/hospitality sector.
Company A is a growing business and seeks to expand its presence across the United States. As a result, it takes out large bank loans to fund growth, has high levels of property, plant, and equipment spending (known as capital expenditures), and is, consequently, placed in a higher tax bracket.
Company B is slower, less capital-intensive, and less inclined to boost its debt levels (known as leverage).
If we look at each company’s bottom line, it might seem like Company B (the slow company) is more profitable. But is that the true story?
In reality, Company A has higher levels of interest, higher depreciation (due to large capital expenditures) and a larger portion of pre-tax income allocated to tax expense (due to the higher tax bracket). This brings Company A’s bottom line down (a lot).
Therefore, if we add back interest, taxes, depreciation, and amortization, we are looking at a new measure of earnings, or more simply:
EBITDA = Sales – Cost of Sales – Operating Expenses
Here, EBITDA represents the proceeds from generating revenue (sell food at a restaurant), less the cost of that revenue (the costs associated with buying the food), and the associated operating expenses (advertising, payroll, travel, overhead). At its core, EBITDA is measuring the true financial performance of a company, or how much revenue is left after costs and operating expenses are accounted for.
It eliminates the effects of financing and accounting decisions made by a company, hence the apples-to-apples comparison.
If we are speaking in terms of EBITDA, we could also calculate it as a margin to sales. That basically means taking your EBITDA value and dividing it by your revenue (called the EBITDA Margin). This ratio represents how much EBITDA you have per $1 of sales generated. More accurately, it reflects the percentage of revenue left after costs of sales and operating expenses are paid for. If you can control and/or improve these two items, you get more EBITDA and net income.
Today, operational improvements are integral in improving business and creating value. I read an interesting piece by the Boston Consulting Group on Private Equity Growth, and I will attach a link here.
Since EBITDA is a discretionary measure provided by companies via their accounting policies, it is important you know how it is being calculated. A high EBITDA level might mask true earnings and not accurately portray what’s going on.
I want to touch back on the relationship between EBITDA and servicing long-term debt. Interest is paid before taxes (so we can remove taxes), and depreciation and amortization are not actual cash outflows (you don’t write a check to someone for depreciation, it’s just something you keep on your books). You are then left with the profitability of a company to pay down its debt.
Though EBITDA can be useful for assessing a company’s profitability and operational efficiency, it might not be the best proxy for true cash flow (what’s left after you pay off capital expenditures and working capital, which is the ability of a company to service its short-term liabilities (debt owed under 1 year) with current assets (things you own that can be converted to cash in under 1 year).
***(if you haven’t heard of depreciation (touchable) or amortization (untouchable), it’s basically the reduction in value of an asset over time due to age. Think of a sofa you buy, and over the years, the leather wears out. If you tried to sell it on the market 10 years from when you bought it, it would probably not be as expensive as when you first purchased it. Amortization applies to intangible assets, like patents, trademarks, goodwill, etc. but has the same concept)