EBITDA = Earnings (revenue) – Expenses (excluding Interest, Taxes, Depreciation, and Amortization.)
In simple terms, EBITDA may be understood as a company’s net income with interest, taxes, depreciation, and amortization added back to it. It is a useful metric with which to analyze and compare current profitability between companies and industries, as it eliminates the effects of financing and accounting decisions. What is left is simply the figure of profit generated with present assets and the operations on products produced and sold. EBITDA was initially coined during the leveraged buyout boom of the 1980s to help assess the ability of a company to service its debts.Nowadays, because of its usefulness in calculating a ‘pure’ profitability figure, the term is very useful in areas of finance focused on assessing company performance, such as securities analysis.
Why is EBITDA so important? As a metric, EBITDA really comes into its own when comparing assets between industries. In some industries, like manufacturing, companies have large amounts of fixed assets which are subject to heavy depreciation charges. In others, a company may have acquired plenty of intangible assets on its books which will be subject to large amortization charges, as is frequently the case with large acquisitions. Analysts required a way to compare these cases on purely their ability to generate profit, without the distorting effects of these accounting and financing requirements, and thus, EBITDA was born, and has become one of the most important financial measurements of value used today.
Finally, one point of caution. EBITDA may be a good metric to evaluate profitability, but of course it does not accurately represent a company’s cash flow. As well as leaving out taxes, interest, depreciation and appreciation, EBITDA also excludes any cash required to fund working capital and the replacement of old equipment, which can be significant. Occasionally, a company may use this as an accounting gimmick to doll up its balance sheet. For this reason, prospective investors must not solely rely on EBITDA alone, but other performance measures to identify any potential issues hidden by a crafty accountant’s sleight of hand.
Did you find this EBITDA definition helpful? Subscribe to our spam-free newsletter to receive regular financial definitions, updates on our latest articles, plus exclusive annotated market reports.