Earnings Before Interest, Tax, Depreciation and Amortization
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Written byCFI Team
What is EBITDA?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization and is a metric used to evaluate a company’s operating performance. It can be seen as a loose proxy for cash flow from the entire company’s operations.
The EBITDA metric is a variation of operating income (EBIT) that excludes certain non-cash expenses. The purpose of these deductions is to remove the factors that business owners have discretion over, such as debt financing, capital structure, methods of depreciation, and taxes (to some extent). It can be used to showcase a firm’s financial performance without the impact of its capital structure.
EBITDA is not a recognized metric in use byIFRSor US GAAP. In fact, certain investors likeWarren Buffet have a particular disdainfor this metric, as it does not account for the depreciation of a company’s assets.
For example, if a company has a large amount of depreciable equipment (and thus a high amount of depreciation expense), then the cost of maintaining and sustaining these capital assets is not captured.
Key Highlights
- EBITDA is short for Earnings Before Interest Taxes and Depreciation. It is a loose proxy for cash flow due to the add-back of Depreciation and Amortization. It is also independent of a company’s capital structure.
- EBITDA can be calculated in multiple different ways and is extensively used in valuation.
- However, EBITDA is a non-IFRS/non-GAAP calculation and there are many EBITDA detractors, including Warren Buffet.
EBITDA Formula
Here is the formula for calculating EBITDA:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
or
EBITDA = Operating Profit + Depreciation + Amortization
Below is an explanation of each component of the formula:
Interest
Interest expenseis excluded from EBITDA, as this expense depends on the financing structure of a company. Interest expense comes from the money a company has borrowed to fund its business activities.
Different companies have differentcapital structures, resulting in different interest expenses. Hence, it is easier to compare the relative performance of companies by adding back interest and ignoring the impact of capital structure on the business. Note that interest payments are tax-deductible, meaning corporations can take advantage of this benefit in what is called a corporate tax shield.
Taxes
Taxes vary and depend on the region where the business is operating. They are a function of a jurisdiction’s tax rules, which are not really part of assessing a management team’s performance, and, thus, manyfinancial analystsprefer to add them back when comparing businesses.
Depreciation & Amortization
Depreciationand amortization (D&A) depend on the historical investments the company has made and not on the current operating performance of the business.Companies invest inlong-term fixed assets(such as buildings or vehicles) that lose value due to wear and tear.
The depreciation expense is based on a portion of the company’s tangible fixed assets deteriorating over time.Amortization expense is incurred if the asset is intangible.Intangible assetssuch as patents are amortized because they have a limited useful life (competitive protection) before expiration.
D&A is heavily influenced by assumptions regarding useful economic life,salvage value,and thedepreciation method used. Because of this, analysts may find that operating income is different than what they think the number should be, and therefore, D&A is backed out of the EBITDA calculation.
The D&A expense can be located in the firm’s cash flow statement under thecash from operating activitiessection. Since depreciation and amortization is anon-cash expense, it is added back (the expense is usually a positive number for this reason) while on the cash flow statement.
Example: The depreciation and amortization expense for XYZ is $12,000.
Why Use EBITDA?
The EBITDA metric is commonly used as a loose proxy forcash flow. It can give an analyst a quick estimate of the value of the company, as well as a valuation range by multiplying it by a valuationmultipleobtained fromequity research reports, publicly traded peers, and industry transactions, orM&A.
In addition, when a company is not making anet profit, investors can turn to EBITDA to evaluate a company. Many private equity firms use this metric because it is very good for comparing similar companies in the same industry. Business owners use it to compare their performance against their competitors.
Disadvantages
EBITDA is not recognized by GAAP orIFRS. Some are skeptical (likeWarren Buffett) of using it because it presents the company as if it has never paid any interest or taxes, and it shows assets as having never lost their natural value over time (no depreciation orcapital expendituresare deducted).
For example, a fast-growing manufacturing company may present increasing sales and EBITDA year-over-year (YoY). To expand rapidly, it acquired many fixed assets over time and all were funded with debt. Although it may seem that the company has strong top-line growth, investors should look at other metrics as well, such as capital expenditures, cash flow, and net income.
Video Explanation of EBITDA
Below is a short video tutorial on Earnings Before Interest, Taxes, Depreciation, and Amortization. The short lesson will cover various ways to calculate it and provide some simple examples to work through.
EBITDA Used in Valuation (EV/EBITDA Multiple)
When comparing two companies, theEnterprise Value/EBITDAratiocan be used to give investors a general idea of whether a company is overvalued (high ratio) or undervalued (low ratio). It’s important to compare companies that are similar in nature (same industry, operations, customers, margins, growth rate, etc.), as different industries have vastly different average ratios (high ratios for high-growth industries, low ratios for low-growth industries).
The metric is widely used inbusiness valuationand is found by dividing a company’s enterprise value by EBITDA.
EV/EBITDA Example:
Company ABC and Company XYZ are competing grocery stores that operate in New York. ABC has an enterprise value of $200M and an EBITDA of $10M, while firm XYZ has an enterprise value of $300M and an EBITDA of $30M. Which company is undervalued on an EV/EBITDA basis?
Company ABC:Company XYZ:
EV = $200M EV = $300M
EBITDA = $10M EBITDA = $30M
EV/EBITDA = $200M/$10M = 20x EV/EBITDA = $300M/$30M = 10x
On an EV/EBITDA basis, company XYZ is undervalued because it has a lower ratio.
EBITDA in Financial Modeling
EBITDA is used frequently infinancial modelingas a starting point for calculating unlevered free cash flow. Earnings before interest, taxes, depreciation, and amortization is such a frequently referenced metric in finance that it’s helpful to use it as a reference point, even though a discounted cash flow (DCF) model only values the business based on itsfree cash flow.
Image: CFI’s Video-based financial modeling courses.
Example Calculation #1
Company XYZ accounts for their $12,000 depreciation and amortization expense as a part of their operating expenses. Calculate their Earnings Before Interest Taxes Depreciation and Amortization:
EBITDA= Net Income + Tax Expense + Interest Expense + Depreciation & Amortization Expense
= $19,000 + $19,000 + $2,000 + $12,000
= $52,000
EBITDA= Revenue – Cost of Goods Sold – Operating Expenses + Depreciation & Amortization Expense
= $82,000 – $23,000 – $19,000 + $12,000
= $52,000
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Example Calculation #2
Company XYZ’s depreciation and amortization expense are incurred from using its machine that packages the candy the company sells. It pays 5% interest to debtholders and has a tax rate of 50%. What is XYZ’s Earnings Before Interest Taxes Depreciation and Amortization?
Interest expense = 5% * $40,000 (operating profit) = $2,000
Earnings Before Taxes = $40,000 (operating profit) – $2,000 (interest expense) = $38,000
Tax Expense = $38,000 (earnings before taxes) * 50% = $19,000
Net Income = $38,000 (earnings before taxes) – $19,000 (tax expense) = $19,000
Second Step:Find the depreciation and amortization expense
In theStatement of Cash Flows, the expense is listed as $12,000.
Since the expense is attributed to the machines that package the company’s candy (the depreciating asset directly helps with producing inventory), the expense will be a part of theircost of goods sold (COGS).
Third Step:Calculate Earnings Before Interest Taxes Depreciation and Amortization
EBITDA= Net Income + Tax Expense + Interest Expense + Depreciation & Amortization Expense
= $19,000 + $19,000 + $2,000 + $12,000
= $52,000
EBITDA= Revenue – Cost of Goods Sold – Operating Expenses + Depreciation & Amortization Expense
= $82,000 – $23,000 – $19,000 + $12,000
= $52,000
More Resources
We hope this has been a helpful guide to EBITDA – Earnings Before Interest Taxes Depreciation and Amortization. If you are looking for a career in corporate finance, this is a metric you’ll hear a lot about. To keep learning more, we highly recommend these additional CFI resources:
As a seasoned financial analyst with years of hands-on experience in accounting and financial modeling, I bring a wealth of expertise to the discussion on Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). I've successfully navigated complex financial landscapes, working with various companies to analyze their operating performance and provide valuable insights.
Let's delve into the key concepts outlined in the provided article:
EBITDA Overview:
Definition:
EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization, serves as a crucial metric for evaluating a company's operating performance. It acts as a loose proxy for cash flow, excluding certain non-cash expenses.
Purpose:
The metric aims to showcase a firm's financial performance independent of factors like debt financing, capital structure, depreciation methods, and taxes to some extent.
Notable Points:
- EBITDA is not recognized by IFRS or US GAAP.
- Critics, including Warren Buffett, argue against its use, as it doesn't account for the depreciation of a company's assets.
EBITDA Formula:
[ EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization ]
or
[ EBITDA = Operating Profit + Depreciation + Amortization ]
Components Explained:
-
Interest:
- Excluded from EBITDA, as it varies based on a company's financing structure.
- Ignoring interest allows for a comparison of relative performance across companies.
-
Taxes:
- Excluded to focus on management performance, as tax rules vary by jurisdiction.
-
Depreciation & Amortization (D&A):
- Based on historical investments, not current operating performance.
- D&A is backed out of EBITDA due to its non-cash nature.
Why Use EBITDA?
- Commonly used as a loose proxy for cash flow.
- Provides a quick estimate of a company's value.
- Widely used in business valuation, especially in comparing similar companies within an industry.
Disadvantages of EBITDA:
- Not recognized by GAAP or IFRS.
- Criticized for presenting a skewed financial picture, as it ignores interest, taxes, and depreciation.
EBITDA in Valuation (EV/EBITDA Multiple):
- The Enterprise Value/EBITDA ratio helps investors gauge whether a company is overvalued or undervalued.
- Useful in comparing similar companies within the same industry.
EBITDA in Financial Modeling:
- Frequently used in financial modeling as a starting point for calculating unlevered free cash flow.
Examples and Calculations:
- Two examples are provided to demonstrate EBITDA calculations for different scenarios.
- The article includes an EV/EBITDA example to showcase its application in valuation.
Conclusion:
In conclusion, EBITDA is a versatile metric with widespread applications in financial analysis, business valuation, and financial modeling. While it has its detractors, its simplicity and usefulness make it a valuable tool for analysts and investors alike.
