Most of us will have heard of the metrics to go towards gauging the profitability of a business. As an investor, you might hear phrases such as net income, gross profit, operating income, and then, of course, there's EBITDA. I'm quite sure all of you have come across it, but sometimes we forget what it actually represents and why we should care. This blog is going to break it all down in simple, relatable terms. By the end, you will find out exactly how EBITDA will help you appraise potential investments.
Key Take-Away
Understanding EBITDA in Simple Terms
Fine, starting with the basics. EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization.
Yeah, we know there are too many terms. But don't worry, we will make it simple for you.
At its base, EBITDA is really just a measure of the profitability of a firm. It is useful for investors largely because it strips away some of the things that can distort a company's real financial performance-a lot in terms of the taxes it pays and how much debt it carries.
Here is an oversimplified breakdown of what each part of EBITDA represents:
Earnings: Just another term for profit—what the company earns after everything else has been paid.
Before: Just "excluding" what's next.
Interest: Companies may sometimes take out loans, and on that loan, they must pay interest. Interest expense isn't included in EBITDA.
Taxes: All companies are taxed, and EBITDA doesn't include this expense.
Depreciation: This is an accounting technique that spreads the life-time cost of a firm's long-term assets such as equipment or buildings over periods of time. EBITDA excludes such costs.
Amortization: This is exactly like depreciation, but it's intangible; referring to patents or trademarks.
Hence, when you look at the EBITDA, what you are seeing in effect is how much money the company is generating from its core business and not weighed down by other obligations.
Why Should Investors Care About EBITDA?
As an investor, you're surely asking yourself: "Why should I bother with EBITDA when there are so many other metrics?" Here are a few reasons why EBITDA is important:
1- Gives a clearer picture of operational performance
It puts emphasis on EBITDA and more on the ability of the company to bring in profit from everyday business operations. On that score, debt and taxes are then stripped out from such figures since these may not readily reflect the firm's real performance.
2- Good for Comparing Companies
Not all companies are created equal. One may have lots of debt, another one because it is located in another country and has tax advantages. EBITDA helps you to compare apples to apples, focusing on operational efficiency.
3- A Leading Indicator in Valuation
EBITDA is widely used by many investors and analysts in valuing a company. The usage is especially prevalent in industries that would involve a lot of capital investment like manufacturing or telecommunications because it focuses cash generated from operations before large non-cash expenses such as depreciation and amortization are factored into accounts.
The Formula for EBITDA
Now that you know what EBITDA is, let's understand the equation, it's not rocket science:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
You can also interpret it in this way:
EBITDA = Operating Income + Depreciation + Amortization
Operating income is that portion of profit a business earns from its core activities, but it does not have any relation with the interest or tax payments. The given figures of depreciation and amortization are part of it because they are non-cash expenses.
Example:
Let's assume you are thinking about a company called "Joe's Tech Gadgets." In this illustration, I have made it simple by creating the Income statement below for Joe's company.
Income Before Taxes : $ 100,000
Interest: $ 10,000
Taxes: $ 15,000
Depreciation: $ 8,000
Amortization: $ 7,000
So to calculate EBITDA, you will add up all these lines together.
EBITDA = $100,000 + $10,000 + $15,000 + $8,000 + $7,000 = $140,000
Therefore, Joe's Tech Gadgets EBITDA amounts to $140,000. This figure means the profit that this company fetched before paying interest, taxes, and accounting for depreciation and amortization.
Why Do Companies Love Talking About EBITDA?
If you haven't noticed, everyone loves EBITDA, and there is good reason for that. It typically makes them look better than if they were to focus on net income, after interest and taxes and depreciation, are deducted. EBITDA can make a company appear more profitable, specifically one with much debt or heavy capital expenditures.
For instance, if Joe's Tech Gadgets has plenty of loans, for example, their net income can be much lower due to the interest payments. But EBITDA excludes the interest expenses, thereby showing them the real amount of money they are making out of their operations, thus portraying a much more rosy picture to the investors.
EBITDA vs. Net Income: What’s the Difference?
So, let's get to the important point here of what is the difference between EBITDA and net income and why you should care about both.
Net income is often referred to as the "bottom line." That's where the profits of a business, after every adjustment-in interest, taxes, depreciation, amortization, and other charges-re-emerge. This is a more comprehensive measure of the company's ability to make profit but does suffer from the effects of some exogenous factors such as interest paid on debt or tax rates, which change for reasons having nothing to do with the firm's underlying business.
EBITDA is also a more focused measure than net income, since it focuses on the operational performance and can be quite handy for comparing companies with varying levels of debt or operating in different tax jurisdictions.
The Limitations of EBITDA
In reality, while EBITDA can be an excellent tool for investors, it is imperative to be quite aware of its limitations. The following are a few things to keep in mind:
1. Ignores Debt and Capital Structure
The greatest criticism leveled at EBITDA is that it bears no consideration for the level of debt a firm carries. A firm carrying a large amount of loans will have the interest payment effect upon its net income, which EBITDA will fail to take heed of. A company therefore could carry very high EBITDA and yet still be unable to service its debt.
2. Doesn’t Account for Capital Expenditures
Companies in the manufacturing or telecommunication industries would, for instance, need to invest heavily in equipment or infrastructure. EBITDA does not denote capital expenditures, which can be pretty big differences in cash outflows.
3. Can Be Misleading
While EBITDA can be useful as a metric, it completely ignores all interest, taxes, and capital expenditures. For this reason, the figure is sometimes misleadingly positive about the company's financial situation. This is precisely the reason for not using EBITDA solely to analyze a company. Plug in other metrics, such as net income or cash flow, to get a full view.
EBITDA vs. Other Profitability Metrics
As an investor, you are no doubt also accustomed to other profitability measures-including gross profit, operating income, and net profit. How does EBITDA stack up to those?
1. Gross Profit: That's just revenue minus the cost of goods sold, or COGS. It describes how effectively a business could manufacture or sell its products, but it shows nothing in the way of operations, interest, or taxes being absorbed.
2. Operating Income: This is like EBITDA but in fact includes depreciation and amortization. This again presents the profitability that a company can record directly from operations, though this happens before interest and taxes, and after taking into account the wear and tear on the assets.
3. Net Profit: This is described earlier. It is the profit after adjusting all expenses from overall profit. It’s the most comprehensive measure but can be influenced by factors unrelated to core operations.
All of these metrics are handy to some extent, but EBITDA is the most valuable for investors wishing to analyze a company's operating performance without being swamped by financial structure or tax situation.
When is EBITDA Most Useful for Investors?
EBITDA comes in so handy for investors in the following cases:
1. When Comparing Companies in the Same Industry?
If you compare two firms in the same industry, EBITDA will give you an idea of which one is better at squeezing out profitability from its operations. This is particularly true for capital-intensive industries , where companies often have large costs for depreciation and amortization.
2. For Evaluating Private Equity Investments
EBITDA is often used by private equity investors as a basis to decide on whether to buy a company or not. It helps them have better clarity on the cash-generation ability of the company, free from interest and tax charges that are non-operational in nature.
3. Leveraged Buyouts
In an LBO, the company is paid for mostly with borrowed money. Because the buyer will have to use future earnings of the company to service that debt, they focus on EBITDA to understand how much cash the company is able to generate to pay for those payments.
How Should Investors Use EBITDA?
EBITDA is an extremely powerful tool that can give you a more clear view of the operational performance of a company, especially when compared with other similar businesses. However, it is not without limitations. As an investor, one should use EBITDA as just one part of your entire analysis but not as a singular part; instead, one should utilize metrics like net income and cash flow to obtain a perfect view of the company's financial health.
What follows from this is an understanding of EBITDA, which dovetails so well to all the broader financials, and will better prepare you for a smart investment. In short, knowing the numbers is key to being an astute investor!
I hope this blog from The Bazaar Guru helps you get a better grasp of EBITDA and how it can impact your investment choices.
Disclaimer: The content on this website is for educational purposes only and should not be considered investment advice. Always conduct your own research and consult a financial advisor before making investment decisions.
Have a profitable day!