Understanding the Pros and Cons of EBITDA

Earnings before interest, taxes, depreciation, and amortization is better known as EBITDA. This is a type of earnings metric used to measure a company’s financial performance.

EBITDA is a measure of revenue performance that includes operating costs but excludes several other parts of a business's finances. In some cases, it can be used instead of a company's net earnings.

If a business is getting a loan or trying to attract investors, EBITDA can be helpful. It gives lenders and investors a view of how a business performs and earns a profit that is different than metrics like operating income, net income, or cash flow.

EBITDA can look like a very strong number. It is not, though, a measure of a company’s free cash flow.

The EBITDA formula became popular in the 1980s. This was when a group of leverage buyout bankers promoted it as a useful way to measure a company's value.

What Is EBITDA?

EBITDA is a way of showing the operations, profitability, and performance of a business. It leaves out any numbers or costs that are not directly tied to these metrics.

Understanding each part of EBITDA will show why each part is left out and what the final result looks like.

Earnings

Earnings are the net profit or net income. When net profit is calculated, though, certain values are taken out.

The EBITDA calculation adds the values back in. This is what the "before" part refers to.

Interest

Interest is left out because it deals with how the company’s debt is structured. Debt structure can show whether the company has made sound financial choices or is a risky investment. It doesn't help, though, to show how well the company performs.

Tax

Money that a business pays in taxes is profit it does not get to keep. All federal, state, and local taxes are removed when measuring net profit.

Taxes are set by where you are, though. They do not show anything about the profitability or viability of a business.

Depreciation

Depreciation matters more for some types of businesses than others.

For example, one with a large fleet of trucks will, at some point, have to sell and replace those trucks. Depreciation, in that case, is a major cost. A company with intellectual assets, though, only needs to keep its licenses and patents up to date.

As a result, depreciation doesn't show how well a company performs.

Amortization

Amortization refers to the process by which a company pays off its debt. It can also mean the way an asset is written off over several years.

In either case, it doesn't reflect on how a company performs or makes a profit. It is added back in for EBITDA rather than left out as it would be for net income.

How Is EBITDA Used by Businesses?

High EBITDA data can show investors that a business is doing well. It doesn't show the full picture, though.

Companies do have to pay interest and taxes and must also account for depreciation and amortization. A full picture of a company's finances should include those things. As a result, EBITDA is not a true measure of how profitable a business is. In some cases, it can be used to hide poor choices. A company could use it to avoid showing things like high-interest loans or aging equipment that will be costly to replace.

Pros and Cons of Using EBITDA

Pros of Using EBITDA Explained

• In some ways, EBITDA is much like the price-to-earnings Ratio (PE ratio). The good thing about EBITDA is that, unlike the PE ratio, it is neutral to capital structure. It lowers the risk of factors that are affected by capital investment and other financing variables.
• EBITDA shows how well ongoing operations create cash flow. It also shows what the value of that cash flow is.
• It can show whether the company is of interest as a leveraged buyout choice for potential investors. EBITDA can provide a big picture of growth. This can show how well the business model is working.
• When a company is purchased, debt is not transferred to the buyer. As a result, a buyer won't care how the business is financed at the moment of the sale. Buyers may be more interested in things like customers and cash flow than in the age of assets or interest on current debts.

Cons of Using EBITDA Explained

• EBITDA ignores the cost of debt by adding taxes and interest back to earnings. It can be used to mask bad choices and financial shortcomings.
• Using EBITDA may not allow you to get a loan for your business. Loans are calculated on a company’s actual financial performance.
• Copyrights and patents expire over time. Machines, tools, and other assets lose their value and use. EBITDA fails to account for or admit to these costs.
• EBITDA ignores or hides high-interest financial burdens.

Other Metrics to Use Alongside EBITDA

EBITDA can be used as a part of a company’s evaluation. To build a complete financial picture, though, though, you need more data.

• Payback Period: This metric is used to measure the time needed for returns to cover costs. Looking at the payback periods of different investments can help show which is a more profitable option.
• Net Present Value: The real cash flow happening at different times. Looking at the net present value of a company can give a fuller image of the company’s profits and financial health. It takes into account the time value of money.
• Return on Investment: This is the ratio between net profits and the cost of an investment. It is often known as a company’s ROI. The higher the company’s ROI, the higher an investor’s gains per dollar spent.
• Internal Rate of Return: This metric is used to calculate the rate of return for an investor in a particular investment.

When you are thinking about investing in a company, you need to know more than just its EBITDA. All of these metrics can give you important data about the risk versus reward of a potential investment.

What EBITDA Means for You

A high EBITDA can make a company look like a smart investment. But you still need to know more details. If you are thinking of investing in a company, look at all its financial metrics, not just its EBITDA.

EBITDA holds some value for seeing how a business performs from year to year. It does not, though, reflect the true value of a company’s liquid assets or real income.

If you look at only EBITDA, you might put your money into a company with high debt to repay, or one that needs to spend a lot of money to replace old equipment and other assets. Looking at other metrics as well will help you make a smarter choice.

Likewise, if you own a business, don't base all your plans on a single number. In many cases, EBITDA might not reflect the true financial health of your company. Rather than using only a single metric, make your financial moves based on the most complete picture you have.