EBITDA definition

EBITDA stands for ‘earnings before interest, taxes, depreciation and amortisation’. It is calculated by taking away the above figures from a company’s total revenue, to give an idea of the profit made before tax and other financial factors are taken into account.

EBITDA can be of use when comparing companies in different industries, or assessing a business that has high value expenses that detract from net profits. Today, most companies will report an EBITDA figure as part of their regular earnings releases, as it presents a way of demonstrating profitability outside of generally accepted accounting principles (known as GAAP).

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Example of EBITDA

Let’s say company ABC’s revenue is $1 million, but it has operating expenses of £200,000 and £50,000 in depreciation and amortisation expenses. The operating income before interest and taxes (known as EBIT) is therefore £750,000. If we then subtract the interest expenses of £50,000, we have an earnings before taxes figure of £700,000, and if taxes are £100,000, then the net income for company ABC is £600,000.

To calculate EBITDA, we take the operating income, and add depreciation and amortisation back to the figure:

EBITDA = 750,000 + 50,000

The EBITDA figure for company ABC is 800,000.

Pros and cons of EBITDA

Pros of EBITDA

EBITDA is useful for comparing the financial strength of two companies because it creates a singular measure of performance, which can then be applied across industries. It considers the differences in expenses and rates and allows analysts to focus on the outcome of operating decisions rather than imposed taxes and payments.

EBITDA is also commonly used in valuation ratios, such as assessing businesses that have high-value expenses, which can detract from net profits.

Cons of EBITDA

The main drawback of the EBITDA metric is that there is the potential for different components to be included, or excluded, by different companies. This can be misleading to traders and analysts. EBITDA can be used to present financial decisions to a company’s advantage, by excluding any debts – this is known as ‘window dressing’ accounts.

Today, most companies will report an EBITDA figure as part of their regular earnings releases. This isn’t mandatory, however, since it’s not one of the Securities and Exchange Commission’s generally accepted accounting principles (known as GAAP).

When using the EBITDA metric, it is important to look at other factors and performance indicators to ensure the company is not intentionally deceiving investors with its accounting figures.

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