EBITDA & EBITA

EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization. As its name suggests, it is created by considering a company’s earnings before interest payments, tax, depreciation, and amortization are subtracted for any final accounting of its income and expenses. The EBITDA of a company gives an indication of the current operational profitability of the business (i.e., how much profit does it make with its present assets and its operations on the products it produces and sells).

Although EBITDA is not a financial metric recognized in generally accepted accounting principles, it is widely used when assessing the performance of companies. It is intended to allow a comparison of profitability between different companies, by canceling the effects of interest payments from different forms of financing (by ignoring interest payments), political jurisdictions (by ignoring tax), collections of assets (by ignoring depreciation of assets), and different takeover histories (by ignoring amortization often stemming from goodwill).

A negative EBITDA indicates that a business has fundamental problems with profitability. A positive EBITDA, on the other hand, does not necessarily mean that the business generates cash. This is because EBITDA ignores changes in Working Capital (usually needed when growing a business), capital expenditures (needed to replace assets that have broken down), taxes, and interest.

Some analysts do not support omission of capital expenditures when evaluating the profitability of a company: capital expenditures are needed to maintain the asset base which in turn allows for profit. Warren Buffett famously asked: “Does management think the tooth fairy pays for capital expenditures?” Depreciation is often a very good approximation of the capital expenditures required to maintain the asset base, so it has been argued that EBITA (“Earnings before Interest, Taxes and Amortization) would be a better indicator.

EBITDA margin refers to EBITDA divided by total revenue (or “total output”, “output” differing “revenue” by the changes in inventory).

Use

Apart from the use mentioned above, EBITDA is widely used in loan covenants, mostly in the following two metrics:

  1. Leverage: Debt/EBITDA. This metric measures the amount of debt in relation to the EBITDA (i.e., how does the debt relate to the operational profit generating ability of the company). Whilst there is no absolute target and whilst leverage ratios differ widely, it can probably be argued that a leverage >3 is unhealthy for most businesses.
  2. Interest Cover: (EBITDA/Interest Expense). This metric measures the ability of a company to generate profit out of its operations to cover interest payments. Again, there is no absolute target for this value, as the ratio that is required obviously depends on taxes, working capital needs, capital expenditures and the repayment needs of the principal. However, it is clear that a ratio <1 is not sustainable for long.

Misuse

EBITDA has increasingly become the key metric to show the “intrinsic operational performance” of the business, i.e., the performance when all costs that do not occur in the normal course of business (e.g., restructuring costs, ramp-up costs, consulting fees for special projects, special legal fees) are ignored. While this is helpful in general, it is often misused by declaring too many cost items as “one-offs” and thus boosting profitability. The resulting metric when such “non-normal” costs have been deducted should be called “adjusted EBITDA” or similar, but this “adjusted” nature is often not shown sufficiently clearly.

Because EBITDA (and its variations) are not measures generally accepted under U.S. GAAP, the U.S. Securities and Exchange Commission requires that companies registering securities with it (and when filing its periodic reports) reconcile EBITDA to net income in order to avoid misleading investors.