Understanding the Pros and Cons of EBITDA
Can calculating EBITDA help your business valuation?
Earnings before interest, taxes, depreciation, and amortization, better known as EBITDA, is a selective earnings metrics used to measure a company’s financial performance. In some cases, it can be used as an alternative to the company's net earnings.
To put it simply, the EBITDA formula allows you to measure your revenue performance while taking operating costs into account and excluding financial considerations. It gives lenders and investors a different view of your profitability and business performance than operating income, net income, or cash flow.
While it may be an impressive number to show potential investors, EBITDA is not a measure of a company’s free cash flow. It is a measure of profitability that became popular in the 1980s when several leverage buyout bankers promoted it as a reliable measure.
What Is EBITDA?
To understand EBITDA, it will help to know what the acronym stands for and why each part is excluded.
- Earnings: The net profit or net income of an organization.
- Before: Excludes certain factors from the equation. Since these are already subtracted from net profits, the EBITDA calculation adds them back in. This makes the EBITDA total higher than the net profit.
- Interest: Interest is excluded from the equation because it deals with how the company’s debt is structured. While this may reveal whether the company has made sound financial decisions or has a reputation for creditworthiness, it’s not useful in determining how well the company performs.
- Tax: All taxes; federal, state and local. Taxes are determined by location and do not indicate the profitability or viability of an organization.
- Depreciation: Depreciation matters more for some types of businesses than others. For example, to a business with a large fleet of trucks or manufacturing equipment, depreciation is a major expense when the time comes to replace equipment. To a company with intellectual assets, they need only to keep licensing and patents up to date. Depreciation is not an indicator of how well a company performs.
- Amortization: A financial term relating to company debt, amortization is, again, not important to company performance.
As you can see, EBITDA excludes the financial information not directly tied to operations, performance, and profitability.
How Is EBITDA Used by Businesses?
High EBITDA data helps convince worried investors that the business is doing well, however, it is misleading. Because companies do pay interest, taxes, depreciation, and amortization, EBITDA is not a true measure of profitability. It can be used to hide poor financial decisions, like high-interest loans or aging equipment that requires expensive replacement.
Let’s look at some pros and cons of using EBITDA.
Pros and Cons of Using EBITDA
Reduced risk of variables
Shows the value in a company’s cash flow
Provides an overview of business growth
No transfer of debt
Can be misleading
May not allow companies to secure loans
Fails to acknowledge a variety of costs
Conceals financial burdens
Pros of Using EBITDA Explained
- In theory, EBITDA is similar to Price to Earnings Ratio (PE Ratio). The good thing about an EBITDA ratio is that unlike the PE Ratio, it is neutral to capital structure. It reduces the risk of variables that are affected by capital investment and other financing variables.
- EBITDA represents the value of a company’s cash flow generated by ongoing operations.
- It is an indicator of how attractive the company is in terms of being a leveraged buyout candidate for potential investors. EBITDA can provide an overview of a business’s growth and show how well the business model is working.
- When a company is purchased, debt is not transferred to the buyer, and how the business is financed currently is not an important metric. Buyers may be more concerned with intangible assets such as customers and performance than in the condition of existing equipment and the debt structure of the seller.
Cons of Using EBITDA Explained
- EBITDA excludes debt expenses of a company by adding the taxes and interest back to earnings. It can be a misleading figure used by companies to mask failures and financial shortcomings.
- Using EBITDA may not allow companies to secure loans. Loans are calculated on a company’s actual financial performance.
- It fails to value depreciation and amortization as real costs. Copyrights and patents expire over time. Machines and resources used in factories depreciate, reducing their value and use. EBITDA fails to acknowledge these costs while measuring a company’s financial performance.
- EBITDA fails to reveal high-interest financial burdens.
Other Metrics to Use Alongside EBITDA
While EBITDA could be used as a part of a company’s evaluation, building a complete financial picture requires additional information.
- Payback Period: This metric is used to measure the time needed for returns to cover costs. A comparison between the payback periods of different investments can aid investors in understanding which is a more profitable option.
- Net Present Value: Considering the Net Present Value of a company could give a more realistic image of the company’s profits and financial health. In a company, net present value or net present worth refers to cash flows occurring at various times. It accounts for the time value of money.
- Return on investment: The ratio between net profits and the cost of investment is calculated as a company’s ROI. The higher the company’s ROI, the higher an investor’s gains as compared to its costs.
- Internal Rate of Return: This metric is used to calculate the rate of return for an investor in a particular investment.
What EBITDA Means For You
While investing, it is prudent to evaluate a company based on all the above-mentioned metrics and not just its EBITDA. While high EBITDA could appear to shed a good light on a company’s profitability, the devil often lies in the details.
These numbers hold some value for year-over-year performance, but do not reflect the true value of a company’s liquid assets or actual income. It could mislead investors to put their money on companies with high debt and interest obligations, or who need to replace depreciated equipment and resources.
Likewise, business owners should not be romanced by rosy-hued numbers that do not reflect the financial health of the company. Rather than focusing on a single metric, make your financial moves based on the complete picture.