EBITDA

EBITDA, or earnings before interest , taxes, depreciation, and amortization, is basically an indicator of a companies' profitability, not their cash flows as some believe.  EBITDA is commonly utilized as a measurement of profitability which can be used to compare two separate companies or even industries; however, it is not GAAP compliant and therefore it may be calculated in any manner that the company wishes.  This method of analyzing a companies income statement became very popular during the leveraged buyout mania back in the 1980s.

EBITDA can be calculated using the following forumla: Operating Revenue - Operating Expenses + Other Revenues.

As the acronym suggests, Operating expenses are calculated excluding Interest Expenses, Taxes, Depreciation, and Amortization.  This is one of the major drawbacks of EBITDA;  many consider it as a technique used by companies to paint a rosy picture even though there may be underlying issues with the true cash flows of the company. 

 

Common EBITDA Metrics

The two most common metics which utilized EBITDA are the interest coverage ratio and the pay-back period. 

The interest coverage ratio is calculated by the following formula:  EBITDA / Interest Expenses. It is a gauge used to measure a companies ability to pay the interest due on their outstanding debts.

The pay-back period is another useful ratio used to calculate the relative ability for a company to repay its debts. The formula used to calculate this is:  Debt / EBITDA.  As you can see, the higher the ratio, the more risk associated with company.

Arguments Supporting EBITDA


Many proponents of this methodology argue that EBITDA is a clear view of the true performance of a company as it removes variables which do not relate to the core business.  For example, interest expenses are at the discretion of the decision makers who negotiated financing.  Depreciation and amortization calculations are also very different between different companies and therefore eliminated from this calculation as well.  Finally, taxes are left out as they can be distorted based on irregular capital gains or capital losses taken in any of the prior years.  In general, some believe that EBITDA will allow for a level playing field when comparing one company against another. 

Arguments Against EBITDA


EBITDA is a great way to size a company up against its peers in a expeditious way; however, it is a great way for a start up company or a company with large capital expenditures to hide their high levels of debt and expenses.  It's usefulness has been questioned by many, especially after markets come down from highly inflated levels.

EBITDA numbers are also very easy to manipulate.  Fraudulent accounting methodologies can be used to increase revenues and since I, T, D, and A are excluded, paint a very promising future for a company; i.e., dot com boom which ended in 2000. 

In reality, when you compare EBITDA to a companys cash flow statement, or free cash flow statement, or even income statement, it lacks in a few key underlying components.  For example, a cash flow statement will net out a companies net income gain(or loss) for a specific period against the companies cash on hand at the end of that same period; EBITDA does not handle this situation.  Secondly, being that EBITDA excludes all capital expenses and many other expenses, it is not as useful as the companies free cash flows statement or net income statement.

Conclusion


The bottom line with EBITDA is that may be an out date methodology in assessing the financial strength of a company.  It does not provide as a true measure of a companies cash flow and that is what a company is all about.  There are too many important factors which are left out and may have a material impact on the health of a company.  The real question to be asked is "does this company have the cash on hand to continue with its operations?"
Tim Ord
Ord Oracle

Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...

Tradingsim.com
Day Trading Simulator

Tradingsim.com provides the ability to simulate day trading 24 hours a day from anywhere in the world. TradingSim provides tick by tick data for...

Send this article to a friend.

Enter multiple addresses on separate lines or separate them with commas.