EBITDA Definition | Formula and History

When it comes to determining a company’s financial success, EBITDA plays a vital role. Although it is not a powerful criteria for measuring a company’s total profitability, it is a trustworthy indicator of a company’s operating performance. We have explained all of the elements related to EBITDA, including the methodology, calculation, benefits, and drawbacks.

EBITDA Full Form

EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization

What Is EBITDA?

EBITDA, or earnings before interest, taxes, depreciation, and amortisation, is a measure of profitability that is different from net income. EBITDA seeks to depict cash profit generated by the company’s activities by excluding non-cash depreciation and amortisation expense, as well as taxes and debt charges based on the capital structure.

EBITDA is a statistic that is not recognised by generally accepted accounting rules (GAAP). Some public firms disclose EBITDA alongside adjusted EBITDA figures in their quarterly results, which often exclude additional expenditures such as stock-based pay.

Companies and investors have increased their reliance on EBITDA, prompting claims that it overstates profitability. The Securities and Exchange Commission (SEC) of the United States requires listed companies reporting EBITDA figures to explain how they were calculated from net income, and it prohibits them from declaring EBITDA on a per-share basis.

How is EBITDA Calculated?

It is primarily computed by deducting from net income a company’s expenses other than interest, taxes, depreciation, and amortisation.

There are two formulas that may be used to calculate EBITDA if you are looking for a solution to how to calculate EBITDA.

• EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortization
• EBITDA = Operating Income + Depreciation + Amortization

Companies use these formulas to efficiently learn about a specific aspect of their business. Because this is a non-GAAP calculation, the user can choose which expenses to include in the net income.

For example, if an investor wants to see how debt affects a company’s financial status, they can omit solely depreciation and taxes.

What does EBITDA Margin mean?

The EBITDA margin describes the relationship between a company’s total earnings and total revenue. The margin is considered to represent how much cash profit a company may produce in a year. It is also useful when comparing a company’s performance to that of its competitors in a given industry.

However, because EBITDA is not included in a company’s financial statements, investors and financial analysts must calculate it on their own.

It is calculated using the following formula:

EBITDA Margin = EBITDA / Aggregate Revenue

Notably, professional buyers are more likely to select a company with strong growth potential if it has a significantly higher margin.

EBITDA Coverage Ratio

The EBITDA-to-interest coverage ratio, also known as the EBITDA coverage ratio, is a financial indicator used to assess a company’s financial strength. It investigates if the firm’s pre-tax income is sufficient to cover its interest-related expenses.

The formula for the EBITDA coverage ratio is as follows:

EBITDA coverage ratio = (EBITDA + Lease Payments)/ (Interest Payments + Principal Payments + Lease Payments)

If the result is larger than 1 or 1, it indicates that the company in question is financially sound. Furthermore, it implies that the company is capable of repaying its debts.

It should be emphasised that there is a fundamental distinction between the EBITDA-to-interest coverage ratio and EBITDA coverage. For example, the former uses earnings before income and taxes, whereas the latter uses a broader EBITDA.

EBITDA History

EBITDA was created by Liberty Media Chair John Malone, one of the few investors with a track record comparable to Buffett’s.

In the 1970s, the cable industry pioneer developed the statistic to help lenders and investors understand his leveraged growth plan, which used debt and reinvested revenues to minimise taxes.

During the 1980s, investors and lenders participating in leveraged buyouts (LBOs) found EBITDA valuable in evaluating whether the targeted companies were profitable enough to service the debt that would be acquired as a result of the acquisition. Because a takeover would almost certainly result in a change in capital structure and tax liabilities, it made sense to deduct interest and tax expenses from earnings. Depreciation and amortisation expense would not impair the company’s capacity to service that debt in the short term because they are non-cash charges.

The LBO purchasers tended to seek companies with limited or modest near-term capital spending plans, while their own need for financing drove them to focus on the EBITDA-to-interest coverage ratio, which compares core operating profitability as measured by EBITDA to debt service expenses.

EBITDA rose to prominence during the dotcom bubble when some companies utilised it to inflate their financial performance.

In 2018, WeWork Companies Inc., a supplier of shared office space, issued a prospectus for its initial public offering (IPO) that defined “Community Adjusted EBITDA” as removing general and administrative expenses as well as sales and marketing expenses.

Advantages of EBITDA

These key points highlight its main benefits.

• The risk of variables that frequently affect financial variables, such as capital investment, is greatly minimised.
• It provides a trustworthy perspective of the company’s growth and the success of its operating model.
• Because a company’s debt is not transferred upon its sale, how a company was financed is typically ignored.
• It represents the actual value of a company’s cash flow created by active operations.
• It is useful to compare a company’s financial efficiency to that of its competitors.
• EBITDA only accounts for expenses that are necessary to keep a company’s day-to-day operations running.
• EBITDA reflects a company’s attractiveness as a candidate for leveraged buyouts.

Disadvantages of EBITDA

The disadvantages of EBITDA are as follows:

• Because debt expenses are removed from EBITDA, the resulting statistic is considered deceptive. It does not reveal the value of a company’s actual earnings or liquid assets.
• Many business owners utilise it to conceal bad financial judgement and other financial flaws.
• It has no effect on high-interest debt.
• It does not include depreciation and EBITDA amortisation as real expenses when calculating a company’s financial performance.
• Companies must employ additional financial metrics in addition to EBITDA to provide a more realistic financial picture.

The difference between EBITDA and Adjusted EBITDA

Adjusted EBITDA standardises cash flow and income and eliminates all types of abnormalities so that EBITDA from two companies may be compared.

When determining adjusted EBITDA, one-time, uncommon, and non-recurring charges that do not directly affect a company’s ordinary operations must be excluded. They are as follows:

• Foreign exchange gains/losses
• Non-cash expenses
• Litigations
• Unrealised one-time gains or losses
• Compensation in the form of shares
• Write-down of assets

EBITDA – Frequently Asked Questions

Ques: What is considered a good EBITDA?

Ans: As previously said, EBITDA is a number that indicates a company’s financial performance and profitability, hence a greater EBITDA is definitely superior to a lower EBITDA.

Ques: What does EBITDA amortisation mean?

Ans: Amortization in EBITDA is an accounting strategy that involves decreasing the book value of intangible assets rather than tangible assets over time. It is disclosed in the financial accounts of a corporation. Intangible assets include non-physical assets such as patents or trademarks, as well as goodwill acquired from previous purchases.

Reminder

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