EBITDA essentially represents net income after adding interest, taxes, depreciation, and amortization back to it, and it is often applied in analyzing and comparing profitability between different companies and industries. It has the advantage of eliminating the consequences of financing and accounting decisions.
EBITDA is an accounting measure that allows a greater amount of discretion as to what is and what isn’t included in the calculation. Companies are able to change the items included in their EBITDA calculation from one reporting period to the next one.
Although EBITDA is not an official financial measure, it is often being used in many finance fields when trying to assess the performance of a company. Its purpose is to make it possible to compare the profitability between different firms by neglecting the effects of interest payments from different forms of financing, collections of assets, political jurisdictions, and different takeover histories.
Types of EBITDA
Earnings before interest, taxes, depreciation and amortization can result in two forms: negative and positive.
Negative EBITDA shows that a business has some fundamental problems with profitability and cash flow.
Positive EBITDA doesn’t necessarily mean that business generates cash, because there may be other expenses not included in the EBITDA but drowning money from the company, such as working capital, capital expenditures, taxes and interest.
Use of EBITDA
There are two most common metrics in which EBITDA is widely used and they are related to loan covenants:
Leverage – it measures the amount of debt in relation to the EBITDA
Interest coverage – it measures the ability of a company to generate profit in order to cover interest payments.
Disadvantages of EBITDA
EBITDA is not suitable to be used as a single measure of earnings or cash flow. When looked at EBITDA individually, it can provide an incomplete and dangerous image of financial health. There are at least four reasons not to rely on EBITDA completely:
It’s not a substitute for cash flow – as mentioned before, there are some real expenses that are not calculated in the EBITDA formula, like taxes and interests. This means that the amount of money that EBITDA shows is almost never realistic.
It skews interest coverage – EBITDA can make company give an impression of having more money to make interest payments.
It ignores quality of earnings – there is no universal standard for EBITDA starting figures, so the amount it represents for different companies may vary a lot.
It makes companies look cheaper than they really are – this reflects on the company’s stock price, among other things.