Investing comes with risk, so it’s necessary to thoroughly research investments before you make them. One popular metric that analysts and other financial advisors use for determining the success of a company is EBITDA. It measures a company’s earnings, excluding certain expenses, to give you an idea of how well a company can handle its operating costs. EBITDA also makes is easier to compare companies across geographies and industries. Let’s break down what EBITDA is, how you calculate it and why you might want to use it.
What Is EBITDA?
EBITDA stands for earnings before interest, tax, depreciation and amortization. Investors and analysts use EBITDA as one way to evaluate a company’s performance. In particular, it gives investors an idea of a company’s cash flow and operating profit. That knowledge helps you understand how well a company can handle its operating costs.
Other common measures of profitability, like net income or profit, don’t always tell the whole story of a company’s finances. EBITDA allows you to more easily compare companies across geographies and industries, without worrying about some of the intangibles that can skew profit numbers.
To create a simple example of EBITDA’s use, consider two companies. They are identical except that one, Company A, gets its financing through equity (from investors) and Company B finances its operations through debt. As you can see in the table below, Company A has higher profit. That’s because Company B has the additional expense of interest on its debt. Company A doesn’t have that expense because it doesn’t have to pay back the equity its investors have.
|Using EBITDA to Compare Two Companies|
|Company A||Company B|
|Cost of Goods Sold||$2,000||$2,000|
|Funding from Equity||$0||$10,000|
|Interest Expense ($10,000 at 10% interest)||$1,000||$0|
|Depreciation of Equipment||$1,000||$1,000|
|Income before taxes (EBT)||$6,000||$7,000|
|Net income (21% corporate tax rate)||$4,740||$5,530|
If you’re just looking the profit numbers, you’d think Company A is a better investment. But at the end of the day, both companies are equal. They simple raised money in different ways. EBITDA makes it easy to see that these companies are more equal than their profit numbers suggest.
Breaking Down the Components of EBITDA
To help you further understand EBITDA, let’s look at the individual components and why we’re excluding them. As a reminder, EBITDA stands for earnings before interest, tax, depreciation and amortization.
- Earnings – In this case, earnings is the same as profit. You can find a company’s profit number on its income statement. You may also see the term “net income.”
- Before – This indicates that we are excluding certain items from the final profit measure. By “excluding” the following items, we mean that we’re not subtracting them from earnings, the way companies usually do on their financial documents. Because the profit number already subtracted these expenses, we need to add them back in. That means EBITDA is higher than a company’s final profit.
- Interest – This is interest that a company pays on its debts. We exclude it because how much interest a company pays depends on the way it’s financed. As you saw in the table above, financing operations through equity or debt can affect your profit numbers and misrepresent a company’s worth.
- Tax – This includes taxes at the federal, state and local levels. It’s useful to exclude taxes because how much tax a company pays depends largely on its location and where it does business. Tax rates are largely out of a company’s control.
- Depreciation – Depreciation can make things confusing because it deals with investments, in the form of physical assets, that the company has already made. It’s good to consider the property and equipment a company has, but it’s important not to overvalue them.
- Amortization – In many cases, the assets a company is amortizing depend on the debt a company has. Because it differs by company and situation, it’s useful to exclude amortization when comparing the value of a company.
How to Calculate EBITDA
EBITDA won’t appear on a company’s financial documents. The law doesn’t require companies to report it. That means you need to calculate EBITDA on your own. Luckily, the calculation is straightforward:
EBITDA = Net Income/Profit + Interest + Taxes + Depreciation + Amortization Expenses
To start, you will need a company’s income statement. This document is also known as a profit and loss statement. At or around the bottom you will see a company’s profit or net income. From that value you can work your way up the income statement, adding back the tax expenses, interest expenses, depreciation and amortization expenses. Depreciation and amortization often appear as one line. Sometimes a company will also break out the individual assets that lead to these expenses. However, there should be one line that lists the total expense. You may also see a line with profit before taxes. Starting with this number instead of the final profit can help speed up your calculations.
Variations of EBITDA
EBITDA, while common, is particularly useful for companies that are capital-intensive. Capital-intensive companies require a lot of investment to produce their goods or services. This heavy investment can result in taking on large amounts and/or regular debt. But depending on how and why you’re analyzing a company, there are a few other metrics you may consider.
EBIT is very common and it’s a useful metric for most companies. It looks at a company’s earnings before interest and tax expenses. EBIT measures a company’s operating income and helps you see if the company is making enough to stay in business.
EBT, earnings before taxes, is also common. Because taxes are largely out of a company’s control, investors like to use EBT for some comparisons. This is especially true for companies that have to pay different federal or state taxes. When you look at a company’s income statement, you will see a value for profit before taxes.
You may also see EBITA in some cases. It’s less common and more often used on an internal basis by companies.
The Bottom Line
EBITDA is an important measurement for investors, financial analysts and investment advisors. The term stands for earnings before interest, tax, depreciation and amortization. We exclude these expenses because they can make it difficult to get a true picture of a company’s profit. That’s also why EBITDA is sometimes more useful than the profit number you find on a company’s income statement. For example, a company that funds itself through debt instead of equity will have a lower profit number. That doesn’t mean it’s worth less, though.
There are also a few variations of EBITDA that people use in certain situations. Ultimately, EBITDA is just one metric to use when you’re researching a company and deciding how to invest your money. It isn’t a standalone measure of success.
Tips to Find Investing Success
- Build a balanced portfolio. Your specific investing goals will determine how you invest your money. For example, someone who has already retired probably wants to invest more conservatively than someone who is 30 years away from retirement. However, experts generally recommend that you minimize investing risk by creating a balanced portfolio. Starting with an asset allocation calculator can help you plan your portfolio according to your individual preferences.
- Talk with an expert. If you haven’t done much investing, it’s especially useful to consult a financial professional. Even if you’ve been investing for years, it’s nice to get a second opinion. Regardless of your experience level, talking with a financial advisor is helpful. An advisor can sit down with you and look at your whole financial situation to help you make decisions. Use our advisor matching tool to find an advisor in your area.
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