Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) Definition
Earnings before interest, taxes, depreciation, and amortization—also called EBITDA—is a record of the amount of money a company generated during a period, before deducting interest costs and taxes, and before taking into account the depreciation and amortization of assets.
A company’s earnings AFTER interest, taxes, depreciation, and amortization is their net income.
EBITDA is usually seen as a measurement of a company’s overall ability to generate cash, not taking into account how much of that cash will be spent on essential expenses.
An important thing to note is that EBITDA does not add back operating expenses and COGS, or the cost of goods sold.
EBITDA can be a useful metric because it is a capital structure neutral.
This means that whether a company is financed by debt, equity, cash flow, or any combination of the three, their EBITDA is not affected.
When one company merges with or buys out another company, capital restructuring is a common practice.
Knowing the EBITDA before changing how a company is financed can help the new owners estimate how restructuring will affect net income.
Where EBITDA Falls Short
EBITDA is not a metric under GAAP, or Generally Accepted Accounting Principles.
Companies are not legally required to disclose their EBITDA but it can be worked out using the information in its financial statements.
However, some investors want to know this number when considering the earnings potential of a company.
EBITDA has some limitations because it ignores factors that ultimately DO affect a company’s bottom line.
It can be manipulated by corporate representatives as a way to fool investors into thinking that a company has a better cash flow than it actually does.
For example, businesses that are financed heavily by debt can report a high EBITDA, but after interest payments, the net income of those companies might be well below industry standards.
This is especially common in companies that are struggling to keep up profits and have to take on additional debt to stay afloat.
If investors aren’t careful, an unscrupulous CEO might try to use their company’s EBITDA to cover up those struggles.
When Is EBITDA useful?
EBITDA can be very informative if used to compare two similar companies.
Because spending money on interest, taxes, and the depreciation and amortization of assets is unavoidable for the majority of companies, corporations in the same industry can be expected to pay similar taxes, use similar assets, and potentially have similar capital structures.
Consider the table below comparing two hypothetical businesses in the same field:
In this example, Company A is financed largely by debt, and Company B is financed entirely by equity.
Looking at their net income alone suggests that Company B is more profitable.
However, when looking at the whole of their expenses, including EBITDA, it’s clear that Company A is far more successful at generating revenue.
Since both companies pay the same taxes and have the same value of assets, Company A is more profitable.
If Company C was evaluating which of those two to purchase, all other things being equal, Company A would be the better choice.
EBITDA is also useful for comparing a company’s past performance with its current performance.
This allows investors to see the rate at which a business’s ability to generate cash is increasing, without being distracted by fluctuations in net income that can be caused by, for example, increased depreciation costs from a recent investment in more assets.
In private acquisitions and mergers, EBITDA is commonly used in this fashion, because it is assumed that the new owners of a company can adjust the capital structure of the acquired company.