It might look like it, but EBITDA is not actually an alien word. It is an acronym that stands for “earnings before interest, taxes, depreciation, and amortization.” As you may have guessed by now, it’s a metric used in the business world. A company’s EBITDA can help you better understand their ability to generate cash flow. It’s also an easy way to look at a company’s overall operating performance and financial health. Many investors and day traders use EBITDA when evaluating which stocks to buy.
EBITDA is often said to be “capital-structure neutral.” That means it doesn’t account for the different ways a company might use debt, equity, cash, or other capital sources to finance their operations. It also excludes non-cash expenses such as depreciation. These may or may not reflect a company’s ability to generate cash that it can pay back as dividends. Another important factor is that EBITDA excludes taxes, which can vary based on a variety of factors. Those factors may increase or decrease a company’s tax liability, which isn’t directly related to their operating results.
The calculation of EBITDA first came to prominence in the mid-1980s, when leveraged buyout investors examined distressed companies that needed financial restructuring. They used EBITDA to calculate quickly whether these companies could pay back the interest on financing deals.
Bankers specializing in leveraged buyouts promoted EBITDA as a tool to determine whether a company could service its debt over a year or two. Looking at the company’s EBITDA-to-interest coverage ratio gave investors a sense of whether they would be able to meet the heaviest interest payments it would face, after restructuring.
Over time, it grew in popularity. It was popularized further during the Dot Com Bubble of the late 1990s and early 2000s. The period was filled with companies who had expensive assets and high debt loads. However, many analysts felt those obligations were obscuring legitimately strong growth numbers.
How It’s Used
EBITDA is a handy tool for normalizing a company’s financial results. Since corporate finances can get a bit complicated, EBITDA generally allows for even a casual observer (ie, investor) to easily evaluate the overall financial health of a business. You should know, however, that it’s not a substitute for other important financial metrics, such as net income.
Items excluded from EBITDA, such as interest, taxes and non-cash expenses, should not be ignored or discounted. EBITDA is most often used to compare two similar businesses or in trying to determine a company’s cash flow potential.
EBITDA is a popular metric because it’s very simple to calculate. Start with a company’s annual Form 10-K or quarterly 10-Q report filed with the U.S. Securities and Exchange Commission (SEC). In that statement you’ll find line items for all the items listed in EBITDA.
- Earnings (net income or net loss).
- Interest expense (sometimes also interest income).
- Income tax expense (sometimes also tax credit).
- Depreciation and amortization (often combined but sometimes as separate line items).
Simply add up all the line items that are expenses, subtract any line items that are income (such as interest income), then add the total to the net income (or net loss) figure. The resulting calculation is all the earnings before interest, taxes, depreciation, and amortization. Or, more simply put, the EBITDA amount.
Many companies also report adjusted EBITDA. This is not the same thing as a standard calculation. It includes additional expenses such as stock issuance, non-recurring expenses, and other material items that affect the results of a standard calculation.
While adjusted EBITDA can be useful, you should also be a bit skeptical of these numbers. It can be used by management to support a narrative that frames the company in the best light possible, which may or not be the reality. Adjusted EBITDA is sometimes criticized for disregarding important financial factors that investors should know about.
Limits of EBITDA
EBITDA can be a useful tool for better understanding a company’s underlying operating results. It’s also handy to compare similar businesses or to understand the impact that a company’s capital structure has on its bottom line and cash flows.
However, using it incorrectly can have a negative impact on a company’s financial returns. Simply put, it should not be used exclusively as a measure of a company’s financial performance. It’s not an all-encompassing magic number. Likewise, it shouldn’t be a reason to disregard the impact of a company’s capital structure either.
Accounts, traders, bankers, and others in finance typically remind that this is only one metric (among dozens of others) to use when doing a financial analysis of a company.
Example of EBITDA
Suppose you want to evaluate two different businesses — lemonade stands, in this case. Each stand has similar revenues, equipment, investments, taxes, and costs of production. However, they have major differences in how much net income they can generate due to having contrasting capital structures.
Lemonade Stand #1 was funded entirely by previous existing equity. Lemonade Stand #2, on the other hand, primarily used debt to fund its operations. The only difference between them is how they choose to finance their operations — one with debt, one with equity.
Since Stand #2 used a large chunk of debt ($1,500 at 10% interest) to finance its operations, it’s less profitable. In terms of net income, it will only make $390 in profit versus the $487.50 that Stand #1 could generate with the same $1,000 in annual sales. However, when compared on the basis of EBITDA, the lemonade stands are equal. Each of them produce $800 in EBITDA from their $1,000 in respective sales.
How EBITDA Helps
By looking at EBITDA, you can determine the underlying profitability of a company’s operations. That allows for easier comparisons to another business. Then we can take those results and gain a deeper understanding of the impact of a company’s capital structure. That is, how their debt, capital structure, and even taxes will impact their overall profits and cash flow.
Doing this type of evaluation can help determine if a company is worth investing in. (Or at what price, at least.) In the example above, Stand #1 would be worth more to investors, since it is able to turn more of its EBITDA into net income. Stand #2 isn’t as profitable because of its debt. To compensate, investors would expect to pay a lower stock price to invest in Stand #2.
As we’ve explained, EBITDA is a measure of a company’s financial performance and profitability. So a relatively high EBITDA is clearly better than a lower one. Companies of different sizes (and in different sectors or industries) can vary widely in their financial performance.
The best way to determine whether a company’s EBITDA is “good” or “bad” is to compare its number with that of its peers. You want to try to make an “apples to apples” comparison. To that end, try to compare companies of similar size, in similar industries, offering similar products and services. Most analysts insist that it’s most beneficial when used to compare similar companies. It’s much less useful if you’re trying to make an apples to oranges comparison.
EBITDA and Personal Finance
While EBITDA is a great number to know about if you’re an avid investor, it doesn’t serve much purpose when managing your own personal finances. Every personal budget has a series of revenue and expenses. While you could run similar calculations to try and figure out your own personal household calculation, it wouldn’t help very much. No one is looking to invest in your household’s cash flow, so why bother trying to determine its health with an EBITDA calculation?
Instead, use the principals of EBITDA to keep your budget on track. Make sure your household has a positive cash flow and doesn’t take on more debt than it can handle. Although your personal EBITDA number isn’t really a thing that matters, it still makes sense to make smart financial decisions that set you up for a better future.
The Bottom Line
EBITDA is a financial metric and tool that is widely used in professional finance to evaluate and determine the health of a company, relative to its peers. It can be extremely useful when considering whether to invest in a company, either directly or via purchasing its stock. However, it’s not a singular magic number that will easily inform you of a company’s overall financial health.
While EBITDA isn’t something that you’re likely to use in your own personal finances, it’s still good to understand what it means. As you invest more of your money towards an eventual retirement, knowing what EBITDA means can help guide some of your investing choices. As always, though, you should perform thorough due diligence before making any investment. EBITDA is only one metric among dozens of others you should consider too.