Once again, thanks for tuning in. Holly Shields here for Kalkine Media. What is EBITDA? Before
we break it down, please give our channel a sub and hit that bell icon to stay ahead of the game.
Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) is a widely applied
concept in accounting to calculate a company's cash flow and profitability.
As a result, market participants and investors keep a close tab
on EBITDA as it helps them make decisions about investments.
Although traditional investors such as Charlie Munger have expressed reservations about EBITDA,
it is widely used in markets, and M&A transactions
are frequently priced using EBITDA-based valuations such as EV/EBITDA (x).
EBITDA is a financial statistic that replaces revenue, profit, and earnings per share.
It also enables us to assess corporate operations and the results of operational
decisions. Non-operating items are excluded to arrive at EBITDA.
EBITDA excludes the impact of capital structures
or debt/equity, or non-cash expenses such as depreciation and amortisation.
How did Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) emerge?
In the mid-1980s, EBITDA was originally recognised as a leveraged buyout metric used by investors
to assess distressed companies in need of financial restructuring.
The leverage buyout bankers highly preferred EBITDA as a method of understanding whether a
company is capable of repaying its debt within the term or not. Calculating the
EBITDA to interest coverage ratio, investors get a hint if the companies can pay interest or not.
Since then, the concept of EBITDA concept has been widely applied in accounting. However,
some critics argue that EBITDA is a way of expressing business operations that
ignores the operating expenses. As a result,
it can become misleading to some people about the actual performance of the company.
How to calculate EBITDA?
The EBITDA metric only focuses on operating income (EBIT),
and on the other hand, it does not consider non-operating and non-cash expenses.
The reason behind excluding such expenses while calculating EBITDA is that it calculates
profitability based on operating income. It avoids discretionary factors such as debt financing,
capital structure, methods of depreciation, and taxes. In other words, it can be said that EBITDA
represents a company's financial performance without reporting its capital structure.
The formula for calculating EBITDA is:
Net income+ Tax+ depreciation+ amortisation.
OR
Operating profit + depreciation + amortisation
Why is EBITDA essential?
EBITDA is important in business as it is a method of analysing operational performance
without the involvement of any capital structure.
It implies that EBITDA does not count the different ways by which a company
might use its debts, equity, cash, or other capital sources to finance its operations.
It is also independent of the non-cash expenses in a business such as depreciation
and amortisation, as it has no relation to the company's operational performance.
Moreover, EBITDA also excludes taxes as it varies with time, the company's revenue, and
many other factors. The EBITDA is also used at times to draw comparisons between two
or more organisations regarding their operating performances.
We can conclude by saying that EBITDA is a handy tool that investors
widely use to understand a company's profitability. It is so because an
investor's decision is directly dependent upon the profitability of the company. Thus,
EBITDA reflects the capabilities of a company if it can pay interest to the investors or not.
What are the drawbacks of EBITDA?
The major drawback of EBITDA is that GAAP and IFRS do not recognise it.
As a result, some investors such as Warren Buffett
are skeptical about using it when it comes to analysing the profitability of an organisation.
It is so because EBITDA represents a company in such a way as if it has never paid taxes,
interests or anything as such or has never experienced depreciation and amortisation.
For example, let us assume that a newly developed startup
may portray its positive sales through EBITDA every year. However, its debts,
taxes, interest payments do not reflect on the EBITDA value. This could be misleading for
investors as it might appear that the startup never paid interest or spent money on debts.
Now that you’re up to speed, check out some of our other videos to boost your financial IQ. If
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our website kalkinemedia.com. This has been Holly Shields for Kalkine Media.