Updated: December 6th, 2022
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.
With EBITDA, context is what will ultimately make it to be useful for business owners, investors, or potential buyers of a business.
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) ways of measuring company performance, 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 of a public company.
In a more practical sense, EBITDA helps you benchmark a business based on its operating performance. Which will, in turn, also give you insight into its operating profits, its growth potential and even help you form an exit strategy.
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!
Many financial analysts use EBITDA as a way to gauge a company’s ability to generate cash flow and pay back debt.
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.
A company’s earnings, tangible assets, non-cash expenses, and tax expenses are important to understand. And these factors are not within the scope of what EBITDA was designed to do.
Still, it’s essential to understand both who invented EBITDA and why, as well as who uses it regularly. This way, you can have a broader perspective of how it can be beneficial and what its limitations are.
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 and potential buyers 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’scash flow.
EBITDA was created as a calculation to provide a proxy for cash flow quickly. All it took was focusing further up the income statement to provide a revolutionary new metric that was there all along!
This method of measuring company performance became popular in the 1980s. Back then, it was used as a way to understand whether distressed companies were worth taking over and restructuring.
Even though EBITDA was popularized over 40 years ago, it still helps potential buyers of a company separate paper expenses from a company’s real growth potential.
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.
This makes it a valuable tool when comparing companies. EBITDA lets you better understand the real valuation range without the noise of external factors that can mislead your perception of an entire company.
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 structure 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.
EBITDA shouldn’t be the only metric you use to understand the decisions of a company’s management team and its impact on its core operations. Other business valuation metrics should also be used in tandem to understand business expenses, industry averages, and other non-operating expenses.
But since EBITDA has been such an industry standard for so long, it will benefit you to gain a better understanding of it and how it influences the decisions of banks and of investors.
If you’re looking to learn more about EBITDA and other crucial financial concepts, Vertical CPA can help. Contact us today to learn more