It is only natural for investors and other stakeholders to determine the health, wealth, and value of a corporate by looking at the cash flow, net income, and revenue. However, a new measure, which has been in place since late 1980’s, is slowly creeping into the corporate world where financial reports and accounts are involved. It is known as EBITDA! This stands for earnings before interest, taxes, depreciation, and amortization.
So, what is EBITDA and what does it entail? Well, technically gives you an idea of your short-term financial efficiency by removing the impacts of non-operating metrics like interest expenses, tax rates, or other intangible assets. EBITDA determines a business’s value before adding the value of interest, taxes, depreciation, and amortization.
Interest is an expense that a company incurs when paying back loans from banks or other financial institutions. Tax is an expense to the business that is imposed by a city or country. Depreciation is the gradual reduction of the value of assets in the industry, while amortization means the cost of intangible assets over time. When all these values are exact, it reflects a business’s operating profitability, which most investors are interested in before they decide to invest in the business.
What does EBITDA do to a Business?
EBITDA is a formula that allows a business owner to measure their financial performance with operating costs in mind. It is a metric that lenders and investors use to determine a business’s profitability. Still, critics have said it is a misleading metric because it does not include other financial obligations like taxes, interests, etc. It may be impressive to show investors, but it does not necessarily reflect the company’s cash flow, though it is still a measure of profitability.
EBITDA is calculated in two ways; the first has income as the critical point while the second uses net income.
EBITDA = Operating Income + Depreciation and Amortization
In this sense, the operating income is the profit a business retains after removing all operating expenses, known as the cost of running a business. Operating income helps in distinguishing financial performance by not adding interest and taxes.
EBITDA = Net Profit + Interest + Taxes + Depreciation and Amortization
When a business calculates EBITDA using both formulas, they may arrive at different figures. The company may have had a one-off adjustment in the past, like the sale of equipment or profit from an investment. Stakeholders need to know what could be the reason for the slight difference.
EBITDA has several pros and cons, as mentioned below:
Lower Risk of Variables
EBITDA gives stakeholders an actual view of how healthy a business is and how the existing model is working. It has a semblance with a price to earnings ratio (PE Ratio), only that the latter is not neutral to capital structure, making EBITDA to have a lower chance of being affected by capital investment and other financial variables.
Indicates Cash Flow Value
The actual cash flow of a business is reflected with EBITDA, which is what potential investors check. Therefore, a higher EBITDA has the potential to attract investors. Usually, it is a good sign that a business can make a profit.
Showcases Business Growth
Every business has competitors, and one of the growth indicators is when a company can stay on the edge of competition. EBITDA showcases a business’s growth by looking at an existing business model, vis-a-vis the profits. That is one growth indicator that stakeholders look out for.
No Debt Transfer
In case a company with EBITDA in place is sold, there will be no debt transfer to the new management. The new buyer is often more concerned with intangible assets like customers and the equipment’s condition within the business.
EBITDA is Misleading to Some Extent
Critics say it can mislead because it does not give the actual value of the business. Instead, it gives the value before other metrics like interests, taxes, etc., are considered.
It may not allow a Company to Secure a Loan
EBITDA easily conceals the financial burdens by not acknowledging several costs, like depreciation and amortization as direct costs, when measuring the financial performance of a business. Without a clear financial chart, financial institutions may not approve loans to such companies.
What does EBITDA mean for an investor? Based on the metrics mentioned, a company with a high EBITDA may appear to be doing well financially, but there is truth in the details. As an investor, you may use EBITDA to determine the value of a business before you invest, but you also need to dig deeper and find its actual weight. Business owners must also not take a high EBITDA for good financial performance. So much is involved that to find the real value of a business, all the metrics must be considered.