By CFO Brew Staff
less than 3 min read
Definition:
EBITDA is an acronym for a formula to gauge a company’s performance, particularly its cash flow and ability to pay off its debts. It stands for earnings before interest, taxes, depreciation, and amortization. (Here, “depreciation” refers to the decline in value of tangible assets over time, such as machinery or vehicles that can break down. “Amortization” refers to when intangible assets, like patents, lose their value.)
- How is EBITDA calculated? EBITDA is calculated in one of two ways: by adding a company’s net income to its taxes, interest expenses, and depreciation and amortization, or by adding a company’s operating income to its depreciation and amortization. (Since net income is operating income minus non-operating expenses such as taxes and interest, the two calculation methods often yield similar results.)
- Reasons to use EBITDA. Investors and other interested parties can use a company’s EBITDA to get a sense of how it compares to other businesses, without taking variable factors such as tax structure and debt financing into account. EBITDA can also make sense as a metric when looking at companies, like manufacturers, that own many assets liable to depreciation, or companies that have a great deal of value in intellectual property, like startups or research-dependent firms.
- Who uses EBITDA? Banks and creditors often look at a company’s EBITDA to assess its ability to make interest payments. A company with a high debt-to-EBITDA ratio, for instance, might struggle to pay off its debts. People looking to buy or sell a company might also examine its EBITDA to get a sense of its profitability.
- Criticisms of EBITDA. Though EBITDA can be useful, it’s not the final word on a company’s performance. Critics of EBITDA charge that it can make companies seem more profitable than they actually are, that it fails to capture the role assets and debt play in profitability, and that it doesn’t account for fluctuations in working capital that can impact a business’s liquidity. Warren Buffett has argued that EBITDA is not “a meaningful measure of performance,” as it emphasizes cash flow and omits depreciation.
- Is EBITDA GAAP compliant? As EBITDA is not a Generally Accepted Accounting Principles (GAAP) metric, companies may calculate it in different ways, and they’re not required to disclose it in financial statements. Still, many opt to include it, or provide an adjusted EBITDA figure—a sign that EBITDA’s a bit more consequential than po-tay-toh vs. po-tah-toh.
