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What to know about EBITDA

“EBITDA” is an acronym that you have probably heard used before, but may not fully understand. The objective of this short article is to shed light on what it means and investigate why so many people misunderstand it.

EBITDA stands for “earnings before interest, taxes, depreciation and amortization.” It is worked out by adding back interest, depreciation and amortization expenses to overall operating income. EBITDA is used to calculate a company’s operating profitability by factoring in the deduction of non-operating expenses, such as interest and other non-core expenses, and non-cash charges, such as amortization and depreciation into the overall income figures.

The Good:

EBITDA can be used to analyze the profitability of companies operating in the same sector. Because it scratches beneath the surface of decisions made by a company’s financing and accounting departments, EBITDA supplies an excellent “apples-to-apples” comparison of companies. For example, an EBITDA-to-sales ratio (the higher the ratio, the higher the profitability) can be used to identify the companies which are the most efficient operators in their industry.

This ratio can also serve in an evaluation of shifting trends in an industry over time. Since EBITDA factors in depreciation and the impact of financing large capital investments in a company’s overall worth, it can be used to compare the overall profitability trends between, for example, “heavy” industries (like the automotive industry) and tech companies.

Furthermore, although new accounting rules (formally known as FAS 142) which have come into effect recently are set to bring accounting practice for calculating profitability closer to EBITDA, EBITDA is still likely to remain the most accurate measure of core operating profitability. So whether you’re looking to do a business valuation in CT or prepare a business for sale in NY, EBITDA is a very important number to keep in mind.

The not so good:

EBITDA tends to fall down due to its failure to assess the importance of cash flow. People who do not understand how EBITDA is best used often overlook cash flow and liquidity, which can be extremely dangerous and misleading when working out the overall health of a company.

Calculating operating cash flow is vital for assessing a company’s ability to continue operations in the future. Cash flow figures incorporate changes in working capital that use/provide cash, such as changes in receivables, payables and inventories. If investors rely solely on EBITDA and neglect to consider changes in working capital in their calculations, they are likely to overlook important indications that a company is making an overall loss because of its inability to sell its services or products.

The Ugly:

If EBITDA is used as the sole metric for making key investment decisions, things will get ugly fast. Because of its simplicity, there is nonetheless a tendency to use EBITDA to evaluate a company’s liquidity. As explained above, this means calculating a company’s overall health runs the risk of misrepresenting the true investment potential of a company since it fails to accurately surmise a firm’s ability to generate cash.

Concluding Thoughts:

EBITDA works well to analyze profit potential because it eliminates some of the more extraneous factors and allows for an “apples-to-apples” comparison. Nonetheless, EBITDA should not be relied on solely. A calculation of a business’s cash flow, which includes the significant factor of changes in working capital, should play a central role in any decisions going forward. A combination of cash flow analysis and EBITDA is highly recommendable because it accurately demonstrates a company’s capacity to continue operating in the future.

The case of the W.T. Grant Company provides a good illustration of the importance of cash flow. W.T. Grant was a general retailer in the pre-mall era and was a blue-chip stock of its day. However, mismanagement leading to high levels of surplus inventory eventually forced the company into heavy borrowing as it strove to keep its head above water. W.T. Grant eventually went out of business because the top analysts of the day had focused only on EBITDA and not taken heed of the perils of the company’s negative cash flow. Do not let your business go the same way as others like W.T. Grant – cash flows are an essential consideration and must be evaluated in conjunction with EBITDA.

 

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