Saxo Group
Summary: This article covers EBITDA, an earnings metric used to compare industry averages and company performances. You can use it to compare the profitability of two companies and find a company's valuation ahead of potential acquisitions. You can also use EBITDA to calculate a company's debt coverage ratio. This metric doesn't include taxes or non-cash expenses, and it's different from operating cash flow.
Between the 1970s and 1990s, the global financial landscape transformed. In the 1970s, modern forex trading began forming, and individual savings accounts became popularised in 1999. The years between also witnessed new financial innovations.
Leveraged buyout investors turned EBITDA into a popular earnings metric to measure a company’s profitability and financial performance in the mid-1980s. The metric was commercialised further during the Dot-com bubble. Because businesses and financial institutions use EBITDA, it’s important to understand what the metric is and how you use it in investing.
EBITDA is short for earnings before interest, taxes, depreciation, and amortisation. EBITDA is an earnings metric that lets you compare industry averages and company performances between two or more organisations in different locations. It helps you understand a company's capital structure and how it affects cash flow.
When using EBITDA to understand a company's valuation, remember that the earnings metric doesn’t account for how businesses use capital sources like cash, equity, and debt to finance their operations. EBITDA also excludes taxes and non-cash expenses, such as depreciation. These are all factors that can manipulate earnings.
Taxes, interest, amortisation, and depreciation are factors out of a company’s control. For example, depreciation looks at inflation and other economic conditions and reduces the value of a company’s assets based on these external factors.
Economic conditions like inflation hold powerful influence across the financial industry, impacting everything from the price of oil to the value of stock market indexes like The Dow Jones Industrial Average (DJIA).
Calculating EBITDA is straightforward. You can find all the information needed for EBITDA calculations on a company’s balance sheet or income statement. The two ways to calculate EBITDA include:
Adding net income, taxes, and interest with amortisation and depreciation
Adding operating income with depreciation and amortisation
Let’s look at an example of calculating a company’s EBITDA using the first method (with net income). Gateway Health is a fictional pharmaceutical company that provided the following figures in its income statement for one year ending December 31:
Net income: $822,451
Income taxes: $21,350
Interest: $101,500
Depreciation and amortisation: $125,000
Using the first method of calculating EBITDA, you would add back Gateway Health’s depreciation and amortisation figure to its net income, income taxes, and interest to equal an EBITDA of $1,070,301.
Be aware there is a difference between EBITDA and adjusted EBITDA. Adjusted EBITDA includes material items and additional expenses like stock issuance. It also includes nonrecurring expenses.
Business valuators and financial institutions use EBITDA to compare companies and industry averages. Here’s an overview of how each uses the earnings metric:
Business mergers and acquisitions happen all the time, but how do you know what companies are worth pursuing and acquiring? Well, that’s one of the main functions of EBITDA. Many business valuators (trained specialists who analyse and value companies) use EBITDA to calculate a company’s valuation ahead of a merger or acquisition.
This is crucial because you want to know how a company performs compared to its rivals before acquiring it. After finding out a company’s EBITDA, you may want to look at other, more profitable options.
Entrepreneurs also conduct EBITDA calculations for business sales. Likewise, investors can calculate a company’s EBITDA before investing in its stock. For example, you don’t want to invest in an ESG company’s stock when it has a poor valuation and a low EBITDA. Generally speaking, low EBITDA margins suggest a company has cash flow or profitability problems.
Bankers use EBITDA for several reasons. First, they use the earnings metric to calculate a business’ debt coverage ratio. Second, bankers use EBITDA to see how much cash flow a company has available.
Whatever this figure is will indicate to bankers if businesses can pay for long-term debt or not. You may also see some financial institutions using EBITDA as part of a debt covenant.
Debt covenants are promises you make to lenders as part of your loan agreements. Common debt covenants include hard financial measures (actions you must meet) and keep-well clauses. Keep-well clauses refer to what companies do (or do not do) while their loan is outstanding.
For example, you can’t incur any additional debt while your loan is outstanding, and you must keep the same management team in place for the loan’s duration.
Before using EBITDA to measure a company’s profitability and financial performance, you should know its drawbacks. One common criticism of EBITDA is that because it’s a non-GAAP measure, EBITDA calculations vary between companies. Some businesses also use EBITDA to distract investors when they are experiencing increasing development costs and capital. Other drawbacks of EBITDA include:
EBITDA has different starting points
EBITDA makes a company’s valuation look less expensive than it is
EBITDA ignores the cost of assets and working capital
EBITDA is a convenient tool if you’re looking for a performance metric that’s straightforward to calculate. However, other financial measures have advantages over EBITDA, such as operating cash flow.
In general, operating cash flow provides a more accurate measure of a company’s valuation and how much cash they are generating, because it includes changes in working capital. When you don’t include working capital, such as changes in payables and receivables, you may miss key evidence showing an organisation is struggling with cash flow.
EBIDTA is a good measure of how a company is performing. However, because it leaves out crucial factors like working capital, do additional research on how much cash a company is generating.
You can use different trading platforms to make informed investment decisions and use other measures like operating cash flow to compile an even more comprehensive overview of how a company's performing.
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