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What is EBITDA and Why is it Important?

You may have seen the acronym EBITDA thrown around in the financial world. It’s a controversial metric, but one that can be very beneficial to investors in the right situation. 

Read on to learn more!

What is EBITDA?

As mentioned above, EBITDA is a financial concept that can provide valuable insights into a company’s financial performance. 

The acronym stands for:

  • Earnings
  • Before
  • Interest
  • Taxes
  • Depreciation and 
  • Amortization 

This is not one of the standard GAAP (generally accepted accounting principles) measures, which means you won’t find it specifically laid out on a company’s financial statements. 

Instead, some companies calculate it separately for disclosure in a 10K filing. Alternatively, it’s a relatively simple figure to calculate yourself using publicly available financial information.

What Does EBITDA Mean?

Understanding EBITDA is relatively straightforward. Let’s start with a company’s profit, also known as net income. 

We commonly think of profit as the amount left over after paying all the associated costs of running a business, from buying supplies to running ads to paying employees. 

EBITDA is an adjusted measure of profit designed to give a different perspective on a company’s finances.

To calculate EBITDA, you’ll first use the company’s financial statements to find the amount spent on interest and taxes, as well as the deductions claimed for depreciation and amortization. The first two are actual costs, while the latter are simply on-paper “expenses.” 

Total these amounts, and then add this to the company’s net income. That’s the company’s EBITDA. It’s that simple!

Is EBITDA Better Than Earnings?

Like many financial metrics, there’s no cut-and-dry “better” option. EBITDA simply measures a slightly different earnings measure  than standard earnings metrics. Therefore, each will be useful in different situations, depending on the company and task at hand. Still, it’s essential to understand both who invented EBITDA and why, as well as who uses it regularly.

Who Invented EBITDA?

The honor of inventing this now-common concept goes to John Malone, the billionaire cable and telecommunications businessman and investor. 

As with numerous financial innovations, it sprung from Malone’s desire to lower his net income and therefore pay less in taxes. 

The primary way he chose to do this was through interest and depreciation expenses. Still, investors were initially wary of this apparently lower profit. 

Malone’s genius came from convincing his investors to ignore the typical earnings number and instead focus on a firm’s cash flow

EBITDA was created as a proxy calculation to quickly provide a proxy for cash flow. All it took was focusing further up the income statement to provide a revolutionary new metric that was there all along!

Who Uses EBITDA?

EBITDA is more commonly used than straight-up earnings in situations where valuation multiples are considered particularly by professionals working in the private equity space. 

The reason is somewhat intuitive when you think about it; EBITDA is an un-levered measure of a company’s finances. This means it doesn’t matter how a company uses debt to finance itself, as any interest expense is added back during the earnings calculation.

Let’s look at an example that illustrates this principle. 

We have two companies, Company A and Company B. They’re precisely the same in all critical aspects – the same industry, size, and financial performance. The difference comes in their financing. 

Company A chooses to raise money from investors but has no debt and makes $100,000 in profit each year. 

Company B doesn’t bring in investors but takes out a loan for the money instead. They pay $10,000 in interest on this loan, meaning they show just $90,000 in profit on the same $100,000 performance as company A.

Should investors view Company A as “better” than Company B?

 

Not necessarily. After all, they’re exactly the same in all of the most important metrics of their business. Where they differ is their funding choices – Company A choosing equity, and Company B choosing debt. 

But funding decisions can and do change all the time. There’s not much stopping Company B from choosing to later raise money from investors and pay off that debt, becoming just as “profitable” on paper as Company A. 

 

 

In the meantime, the current choices left Company A’s shareholders with permanently diluted value, while Company B simply has an added financial expense to the business.

Again, there’s no “right” financing choice, even for companies within the same industry and of the same size. Using EBITDA to eliminate the impact of financing allows easier apples-to-apples comparisons of business fundamentals. That’s why it’s so popular among private equity and similar investors.

Want a Better Understanding of EBITDA?

To recap our most important points: 

EBITDA is a valuable non-GAAP measure that’s simple enough to calculate yourself. It’s a more frequently used metric than earnings when valuations are considered, like in the private equity space. That’s because this un-levered measure strips out the impact of financing choices made by a company, revealing pure business performance.

If you’re looking to learn more about EBITDA and other crucial financial concepts, Vertical CPA can help. Contact us today to learn more!

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