The value of a business can be expressed in many ways and using different types of indicators. One of these is EBITDA, whose popularity began back in the 1990s and is still considered by many managers to be one of the main predictors of business success. What exactly is EBITDA and how is it calculated?
What exactly is EBITDA?
The term EBITDA (Earnings before Interest, Taxes, Depreciation and Amortisation) is used to describe the profit generated by a business before deducting from it:
- finance costs (interest on borrowed capital);
- taxes;
- depreciation and amortisation.
EBITDA is used to measure a company’s profitability. It is used in the calculation of a company’s creditworthiness, the valuation of a company for the purposes of an M&A transaction or the disposal of a company, and as a measure of a company’s level of growth dynamics.
Reference to EBITDA makes it possible to answer the elementary question – Is the company operating efficiently and, if so, how high is this efficiency? The literature indicates that EBITDA is one of the so-called absolute accounting measures, as opposed to indicators of a relative nature, such as ROI or ROE.
EBITDA is also one of the guidelines for investors, as it reflects in a way the incremental potential of a company and can determine the purchase (or sale) of financial instruments.
How do we understand the different elements of EBITDA?
Let’s look at the individual values that make up the profit expressed by EBITDA:
- Interest (Interest) is the interest cost of debt less finance income. A good example is, for example, a working capital loan from a bank. The higher the interest rate of the loan taken out by the company, the higher this element of the equation will be.
- Taxes (Taxes) are public law charges on the income tax level paid by the company. Depending on the organisational and legal form, this may be PIT (e.g. for a general partnership of natural persons) or CIT (e.g. limited liability companies and joint stock companies). This category does not include VAT and PIT paid for employees.
- Depreciation and Amortisation reflects the loss over time of the economic value of tangible and intangible assets (e.g. trademarks, licences). Depreciation and amortisation is referred to as a non-cash cost because there are no economic shifts associated with it, although the given value becomes less and less over time.
A slightly more flexible form of EBITDA is EBIT, i.e. profit that also includes the value of depreciation and amortisation, but already without taxes and capital service costs.
Is there a unified form of EBITDA?
The company’s profit expressed by EBITDA for many companies is considered to be the most important next to EBIT (or the company’s ‘pure’ operating profit) and net profit. In practice, there may be differences in the way EBITDA is calculated depending on the company’s accounting policy as well as local regulations. Therefore, it will not always be possible to compare two companies with each other using only this one indicator and even when they operate within the same sector.
It is enough that the companies use a different level of machinery or rely on a different type of financing for the EBITDA result to be different.
The assessment is not facilitated by the fact that companies may use two values in parallel, the amounts of which will not coincide at all. These values for ‘ordinary’ EBITDA (in accounting terms) and adjusted (normalised) EBITDA. Which adjustment is being referred to? Analysts point primarily to:
- justified capital transfers;
- non-recurring events;
- estimated valuation of mandatory reserves;
- events not related to current business activities;
- the manner in which long-term contracts are accounted for.
In many cases, it may be that adjusted EBITDA will perform better, as it is more reflective of the volatility of the economic environment in which the company operates, as well as a realistic snapshot of business processes. The adjusted approach is used in M&A processes, among others.
When is EBITDA used?
EBITDA is used to measure a company’s cash flow. Within certain limits, it can be used to assess profitability, although it does not take into account the economic impact caused by investments made in previous years.
Economists also use EBITDA when comparing the financial health of a company year-on-year. It is one method to assess the trend in value change. The ratio can also be one of the guidelines for determining the price of a company for sale, or at least the price range to be negotiated.
The EV/EBITDA ratio is often used to assess the value of a company, as it is strongly linked to the current value of the shares. It is sufficient to multiply EBITDA by the EV/EBITDA ratio to obtain an estimate of the value of the company.
Disadvantages of the EBITDA model
Among the disadvantages of EBITDA, the main one is the overstatement of cash flows, which can lead to unrealistic estimates. The indicator does not take into account the value of cash flows related to investments in assets (both fixed and non-fixed) or changes in working capital (e.g. inventories, receivables and short-term investments).
It is also worth pointing out that EBITDA does not take into account a range of costs associated with the operation of the business, including fixed asset investments and finance costs associated with servicing capital. Vulnerability to error means that EBITDA can become the basis for unjustified analytical, as well as business, decisions. Is it then not worth using it at all? Certainly not, but it should be approached with caution and used as an auxiliary, but not the only, instrument in assessing business profitability.
Knowledge of EBITDA is of great importance to business managers. It is also used by analysts, investors and competitors to compare the value of their company with other market participants. It is worth being aware of the limitations associated with this way of expressing profit, so that business decisions can be accurate and generate even more profit.