What is EBITDA and why do we use it?
EBITDA means earnings before interest, taxes, depreciation, and amortization, and is a useful indicator for understanding the ability of a business to generate cash flows for its owners and for evaluating the company's operations.
The advantage of using EBITDA to measure a company's performance is that it is capital structure-neutral by including debt and taking earnings before the payment of interest. Thus, it is not affected by decisions such as how the company finances its balance sheet (debt or capital, or a combination of both). In addition, it also excludes non-cash expenses, such as depreciation, which may or may not reflect the company's ability to generate cash, which it can return as dividends to its owners.
EBITDA can be used to analyze and compare profitability between companies and industries, as it eliminates the impact of financing and capital expenditures.Normally, the indicator should be positive. If not, then this means that the company is unprofitable at the level of operating activity and is unable to service loan debt. However, a positive EBITDA does not mean that the company has a profit. After all, payment of interest, accrual of taxes and depreciation can lead to loss.
In the table below you could see the difference in EBITDA for 2 companies due to debt or capital financing. Company A was funded entirely by equity. Company B uses debt to fund its operations. The only difference between them is how they choose to finance these assets -- one with debt, one with equity.
EBITDA comparison (in k USD)
Company nameComapny ACompany B
Revenue2 0002 000
Cost of goods sold400400
Interest expense0300
Income before taxes1 5001 200
Tax rate (40%)600480
Net Income900720
EBITDA1 6001 600
Should I use EBITDA when evaluating the financial results of an enterprise?
Perhaps it all depends on the purpose of the analysis. EBITDA does not take into account factors related to the size of the enterprise and the volume of investment. It ignores debt burden and taxation system taking into account parameters related only to operating activities. Therefore, this indicator is excellent for analyzing and comparing various enterprises operating in the same industry, as well as for assessing the company's net operating results.
However, depreciation costs, which are almost impossible to avoid due to depreciation of machinery, equipment and other assets, are not taken into account in calculating EBITDA. Ignoring depreciation can lead to a shortage of money in case if fixed assets need to be updated.
The concept of EBITDA should be used carefully, and you need to pay attention on other indicators of profitability. You always need to remember that sooner or later there will come a time when enterprise will need to update its production facilities. And of course, this will require money.