The acronym EBITDA stands for earnings before interest, taxes, depreciation and amortization. EBITDA is a useful measure for understanding a company’s ability to generate cash flow for its owners and for judging a company’s operational performance.

Why EBITDA matters

EBITDA is a capital structure neutral measure of earnings, which means that it does not take into account the different ways a company can use debt, equity, cash or other sources of capital. to finance its operations. It also excludes non-cash expenses such as depreciation, which may or may not reflect a company’s ability to generate cash that it can repay in the form of dividends. In addition, it excludes taxes, which can vary from period to period and are affected by many conditions that may not be directly related to a company’s operating results.

Overall, EBITDA is a handy tool for standardizing a business’s results so that you can more easily assess the business. To be clear, EBITDA is not a substitute for other metrics such as net profit. After all, the items excluded from EBITDA – interest, taxes and non-cash expenses – are always real items with financial implications that should not be ignored or ignored.

EBITDA is often more useful for comparing two similar businesses or for trying to determine a company’s cash flow potential.

How to calculate EBITDA

EBITDA is very easy to calculate. Start with SEC Form 10-K or a company’s 10-Q Quarterly Report filed with the United States Securities and Exchange Commission. Go to the income statement, and you will find items for all EBITDA items:

• Gains (net income or net loss)
• Interest charges (sometimes also interest income)
• Income tax charge (sometimes also tax credit)
• Depreciation and amortization (usually combined, but sometimes as separate items)

Then add up all of the line items that are expenses, subtract all of the line items that are income (such as interest income), and then add the total to the net income (or loss) figure. The result is earnings before interest, taxes, depreciation and amortization, or EBITDA. In other words, you add all the expenses in those categories to the net income of the business (and subtract the earnings from them).

Note: Many companies also report adjusted EBITDA. This is do not the same as EBITDA since it includes additional expenses such as issuance of shares, non-recurring expenses and other significant items that affect results. While Adjusted EBITDA can be useful, it can also be used by company management to support a narrative that frames the company in the best light while ignoring investors. should factor in their analysis and not to ignore.

The limits of EBITDA

EBITDA can be a useful tool to better understand a company’s underlying operating results, compare them to similar companies, and understand the impact of the company’s capital structure on its results and flows. cash. However, improper use of EBITDA can negatively impact your returns. EBITDA should not be used exclusively as a measure of a company’s financial performance, nor as a reason to ignore the impact of a company’s capital structure on its financial performance.

EBITDA should be considered just one tool among many in your financial analysis toolbelt. The example below explains why relying only on EBITDA can be a mistake.

Why EBITDA: an example

Suppose you want to evaluate two companies. To keep this example easy to follow, we’ll be comparing two lemonade stands with similar revenues, equipment and ownership investments, taxes, and production costs. But they will have big differences in the net income they generate due to the differences in their capital structures.

Lemonade Stand A was fully funded by equity. Lemonade Stand B primarily uses debt to finance its operations. The only difference between them is how they choose to finance those assets – one with debt, the other with equity.

Income statements for these two lemonade stands appear below.

Note that Lemonade Stand A generated net profit of $ 487.50, while EBITDA was $ 800 in the example year.

Because Lemonade Stand B uses significantly more debt ($ 1,500 at 10% interest) to fund its operations, it is less profitable in terms of net income ($ 390 in profit vs. $ 487.50). However, when compared on an EBITDA basis, the lemonade stands are equal, each producing $ 800 in EBITDA versus $ 1,000 in sales last year.

What’s the lesson here? By looking at EBITDA, we can determine the underlying profitability of a company’s operations, which allows for easier comparison with another company. Then we can take these results and better understand the impact of a company’s capital structure, for example, debt and capital expenditures, as well as tax differences (especially if companies operate in different locations ) on the actual profits and cash flow of the business.

Doing all of this can go a long way in helping you decide if a business is worth investing in and at what price. In the example above, Lemonade Stand A would be worth more to investors because it is able to turn more of its EBITDA into bottom line. Lemonade Stand B is not as profitable due to its debt load, so investors should be compensated by paying a lower price Stock the price.