EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) is a financial metric used to evaluate a company’s profitability and overall financial performance. But why is it important and how to analyse it? Read to know!
What is EBITDA?
EBITDA measures the cash flow generated by a company’s entire operations. This means that it looks straight at the profitability generated by a company before adding expenses like interest, taxes, depreciation, and amortisation.
By excluding non-operating and non-cash expenses, EBITDA eliminates factors beyond the business owner’s control, such as capital structure, depreciation methods, debt financing, and taxes.
When EBITDA is positive, it indicates that the company is generating profits at the operational level, as the revenue from selling its products exceeds the production costs. Conversely, negative EBITDA suggests a cash flow issue within the company.
Why is EBITDA Important?
1. Industry Comparison
EBITDA proves to be a valuable tool when comparing the financial performance of companies operating within the same industry. Investors examine the EBITDA figures of industry peers to gain insights into profitability trends, operational efficiency, and overall financial health. By comparing a company’s EBITDA margin (EBITDA as a percentage of revenue) to industry averages, investors gauge its competitive position.
For instance, if a company has an EBITDA margin of 15% while the industry average is 10%, it suggests that it is performing relatively well in generating profits.
2. Detecting Overvaluation or Undervaluation
EBITDA is instrumental in identifying potential overvaluation or undervaluation of a company. Investors can compare a company’s EBITDA multiples to those of its industry peers to assess its relative value. If a company’s EBITDA multiple is significantly higher or lower than the industry average, it could indicate an overvalued or undervalued condition, respectively.
Calculating EBITDA
To calculate EBITDA, you need to check the income statement, which contains figures for earnings (net income), taxes, and interest. At the same time, data for depreciation and amortisation is typically found in the operating profit or cash flow statement.
There are two formulas commonly used to calculate EBITDA.
Formula 1:
EBITDA = Net Income + Taxes + Interest Expense + Depreciation and Amortisation
Formula 2:
EBITDA = Operating Income + Depreciation and Amortisation
Depreciation pertains to the reduction in the value of tangible assets over their lifespan. Tangible assets that can be depreciated include plants, equipment, machinery, buildings, and furniture.
Amortisation, on the other hand, refers to the reduction in value of intangible assets over their lifespan. Examples of intangible assets subject to amortisation include patents, trademarks, lease rental agreements, concession rights, and brand value.
The EBITDA calculation does not include interest expense because it depends on the company’s financing structure. It represents the cost of funds borrowed by the company to support its operations. Different companies have varying capital structures, leading to different interest costs.
As interest expense is considered non-operating revenue, it is excluded from the EBITDA calculation.
EBITDA Errors
It is important to note that EBITDA is not officially recognised by Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). Consequently, there is scepticism regarding its use, with notable critics such as Warren Buffett.
This scepticism arises because EBITDA portrays a company as having not incurred any interest or tax expenses while disregarding the natural depreciation of assets over time.
To illustrate, consider a rapidly expanding manufacturing company that reports increased sales and EBITDA year-over-year. However, this growth may be attributed to the company acquiring numerous fixed assets over time, which were financed through debt. In such a scenario, the strong top-line growth may be misleading.Therefore, investors should exercise caution and consider other metrics alongside EBITDA when evaluating a company.
Conclusion
EBITDA offers valuable insights into a company’s operating performance, but it is essential to recognise its limitations.
EBITDA does not consider factors such as changes in working capital, capital expenditure, or non-operating items like one-time charges or extraordinary expenses. Therefore, it is advisable to use EBITDA alongside other financial metrics to gain a comprehensive understanding of a company’s financial health. Relying only on EBITDA may lead to an incomplete assessment of the company’s financial situation.
*The article is for information purposes only. This is not an investment advice.
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