You’ve probably heard the term 'EBITDA' but might not know exactly what it means. What is it? What is it used for? And How do you calculate it? You’ll be able to answer these questions by the end of this video.
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It evaluates a company’s performance as neutral of capital structure, tax structure, and certain accounting policies. The items are excluded because they are not the result of core business operations and are often influenced by external forces.
The capital structure of a company is the combination of debt and equity used to finance its operations. EBITDA minimizes the impact of the capital structure on the core operations. By excluding interest expense, EBITDA neutralizes the cost of debt. Companies are typically sold debt free, so the expense related to financing is not crucial to a potential acquirer. Also, a potential acquirer may obtain financing in different amounts and with different interest rates, so current owners’ interest expense is not important to them.
The tax structure of a company is influenced by external forces, specifically tax rates, which are not in the control of the business operator. By excluding tax expenses, EBITDA eliminates that variable. Tax expense can distort net income for losses in prior years and may not reflect current performance. Additionally, a buyer may operate the business in a different state or under a different type of legal corporation structure, which will result in different tax rates.
Depreciation and amortization expenses are used to account for the cost of assets over their useful life – specifically, capital assets that will generate revenue. GAAP accounting is accrual based, which requires that expenses match the associated revenues. Therefore, we must account for the expense of these assets over their useful life because they will generate revenues across their useful life. Depreciation is used for tangible assets such as machinery, vehicles, or equipment. Amortization is used for intangible assets like software or goodwill from past acquisitions. These expenses are considered “non-cash,” and are purely accounting expenses. The cash left the company when the asset was purchased. The company will benefit from that asset over its entire useful life, which is why we use depreciation and amortization to account for the expense over its useful life. There are different accounting policies for depreciation and amortization, such as straight line and double-declining balance. Net income is significantly impacted depending on which accounting method the company uses. We exclude it from EBITDA to neutralize the decision of using whichever accounting policy.
Why Use EBITDA?
Investors, creditors, and business owners use EBITDA as a proxy for cash flow generated by the core business. It is useful for decision-making – specifically, if you are deciding whether to buy, sell, or invest in a business. Or if you are trying to compare a business to an alternative investment or competitor. Lenders will often look at EBITDA to determine whether a company can meet its short-term obligations and be compliant with its debt covenants. The best use of EBITDA is leveling the playing field between two companies to neutralize the effects of capital structures, tax structures, or accounting policies.
EBITDA Levels the Playing Field
Below are the income statements of Company One and Company Two. These companies operate similar businesses in the same industry.
Both companies generated $15 million in revenue last year and had $5 million in cost of sales or direct expenses, which results in $10 million in gross profit.
Company One had depreciation and amortization expenses of $500,000 compared to Company Two’s $1.5 million. That likely means that Company One has fewer capital assets or they are more depreciated.
Company One has $1 million more general and admin expenses compared to Company Two.
Company One has interest expense of $500,000, significantly less than Company Two’s $2 million. This likely means that Company Two holds more debt, or has a much higher interest rate.
Company One generated $6 million in profit before tax and Company Two generated $4.5 million. For this example, we assumed a 40 percent tax rate for both companies, so provision for income tax expense is directly attributable to their differences in profit before tax, resulting in net income of $3.6 million for Company One and $2.7 million for Company Two.
Which Company Generated More Cash?
You might think Company One because of the higher net income, but you would be mistaken. When we exclude interest and taxes, you are left with operating income, or EBIT. We then add back depreciation expense to calculate EBITDA. Company One generated $7 million, and Company Two generated $8 million. Thus, Company Two was operating more efficiently and generated $1 million more of cash annually than Company One. So, if you chose Company Two, you would be correct. Company Two generated more cash.
As you can see, EBITDA is a very useful metric for analyzing how efficient a company is at generating cash, but sometimes it is not the whole story. Adjusted EBITDA incorporates other add-backs that do not represent core business – specifically, core business expenses, such as non-business-related expenses as owners’ compensation or nonrecurring or extraordinary add-backs, which is a one-time legal expense.
Please check out PCE’s Add-backs video for more details on how to identify add-backs to calculate adjusted EBITDA, which could help you defend a higher valuation.