Understanding EBITDA

EBITDA, Earnings Before Interest, Taxes, Depreciation, and Amortization is a key metric used as an effective measure to provide insights into operational profitability and efficiency. It reflects the cost structure of the business and its ability to earn margin on what is a comparable revenue stream between businesses that compete for the same $. Here is a view of what EBITDA is, how it is calculated, and why it matters to business.

What is EBITDA & Why is it Important?

EBITDA is an alternate measure of profitability to net income that indicates a company's ability to generate gross profit from its main business operations. It excludes impacts from financing costs, tax expenses, and non-cash accounting such as depreciation and amortization giving a picture of the organization's operational performance and cash flow potential. This measure makes it easier to compare companies competing in the same industry irrespective of financing structure. Investors and stakeholders use EBITDA to gauge a company's financial health and operational performance.

Calculating EBITDA?

Simply put the formula for EBITDA is:
EBITDA = Net Income+Interest+Taxes+Depreciation+Amortization.

EBITDA Comparisons & Business Utility

Understanding the differences between EBITDA, EBIT (Earnings Before Interest and Taxes), and Net Income and the business utility of their use is important in terms of:

The Breakdown of Each Component (Definitions)‍

• Earnings (Net Income): Subtracts interest, taxes, depreciation, and amortization from operating income, representing the company's profitability after all expenses.‍
• Interest: Costs incurred from borrowing funds.‍
• Taxes: Income tax expenses the company must pay on its profits.‍
• Depreciation: Reduction in value of tangible assets over time.‍
• Amortization: Gradual reduction in value of intangible assets like patents or trademarks.‍
• EBIT: Like EBITDA but excludes depreciation and amortization. It measures operating income before interest and taxes.

Decision-Making Support

• Investors and Analysts: Understanding these metrics helps investors and analysts evaluate a company's financial situation, compare it with competitors, and make informed investment decisions.‍
• Management: These metrics help management make strategic decisions by highlighting different aspects of financial performance. EBITDA can inform about operational efficiency, EBIT about operating performance after considering asset usage, and Net Income about overall profitability.

Making Company Comparisons

• Cross-Industry Comparisons: EBITDA is useful for comparing companies competing in the same industry with varying capital structures and tax environments. It levels the playing field by focusing on operational performance.
• ‍Operational Efficiency: EBIT allows for a comparison of companies based on their operating efficiency, considering the cost of asset utilization.‍
• Profitability: Net Income provides a comprehensive view of profitability, accounting for all financial and operational expenses.

Valuation and Performance

• Valuation: EBITDA is often used in valuation multiples (e.g., EV/EBITDA) to assess the value of a company. It highlights cash flow potential by excluding non-cash expenses. In a buyout scenario, a higher EBITDA can indicate a more attractive candidate due to better cash flow from operations.
• ‍Performance Metrics: EBIT helps evaluate how effectively a company generates profits from its operations, which is crucial for assessing operational management.‍
• Bottom-Line Profitability: Net Income is a key indicator of a company's overall financial success, important for shareholders and stakeholders interested in the company’s profitability after all expenses.

Each financial metric offers distinct insights into various aspects of a company's financial health. Grasping the differences between EBITDA, EBIT, and Net Income enables a more nuanced analysis of financial performance and supports more informed business decisions.

What are the Criticisms & Limitations of EBITDA?

While EBITDA is useful, it has its critics. It can oversimplify a company's financial situation by excluding vital components like capital expenses and debt servicing costs. It does not follow US Generally Accepted Accounting Principles (GAAP), as it excludes real expenses like interest, taxes, and depreciation (see point 2 below for clarification).

Adjusted EBITDA, which excludes non-recurring expenses, can sometimes paint an overly favorable picture. The following are considerations about EBITDA as regards exclusions that could impact the decision-making process:

Core Expenses Excluded

• Capital expenditures needed to sustain and grow the business are often substantial and these are not accounted for in EBITDA.
• Cost of debt and impact of tax are excluded and most argue these as critical to understanding the financial well-being of a company.
• Non-cash expenses that form part of a declining asset base can be significant arguing in favor of including depreciation and amortization which EBITDA does not.

Non-US GAAP-Compliant
A standard like US GAAP (Generally Accepted Accounting Principles) is intended to ensure consistency in financial management and calculations. EBITDA is not a metric recognized under US GAAP, and therefore it is a non-GAAP financial measure. As such there is some criticism that it may not be subject to standardized definitions and could therefore well be calculated differently by different companies. All the same, it is widely used, remains one of the most popular non-GAAP earnings measures and is often reported as operating profits in a company's Annual Financial Statements.

Potential for Manipulation
Since EBITDA excludes various expenses, companies could use it to paint an overly favorable picture of their financial performance. Adjusted EBITDA looks to normalize earnings and remove events not anticipated to happen regularly. Typically, these include:

• Non-Recurring Expenses: One-time costs not part of the regular business operations, such as restructuring charges, legal settlements, and expenses related to mergers and acquisitions.
• Non-Cash Items: Expenses that do not involve actual cash outflows, including stock-based compensation, impairment charges, and unrealized gains or losses.
• Irregular Income or Expenses: Gains or losses from the sale of assets, gains from lawsuits, and any other income or expenses that are not part of the company's usual business activities.

Not a Reflection of Cash Flow
Simply put EBITDA does not equal cash flow because it ignores capital expenses, working capital changes, and other cash movements, critical to understanding liquidity and financial flexibility.

Over-Simplification
With the focus on operational performance excluding major costs, it can distort the truth and even mislead analysts and investors regarding profitability and risk in the business. The point is that extremely profitable companies can be poorly leveraged and cash-managed, and they fail anyhow. So, a good way to view EBITDA is alongside ROI/ROA and vice versa. Under-leveraged, highly cash flow lucrative businesses with low margins and EBITDA can be successful as is the case with the world's largest online retailer and multinational technology company.

Interest and Debt
In highly leveraged organizations disregarding interest expenses can be disingenuous while the cost of servicing debt may have a major impact on financial stability and overall profitability as these are not captured by EBITDA.

Implications from Tax
Death and taxes are the only two certainties in life, the latter being a real cost of business, which if excluded from profitability measures could deliver an incomplete picture of financial performance, more so for companies with complex tax structures.

Some Practical Implications of EBITDA
EBITDA remains a valuable tool for business owners, lenders, and investors:

• ‍Business Owners: Gain insights into operational performance and guide strategic decisions.
• ‍Lenders and Investors: Assess a company's ability to service its debt and make investment decisions.
• ‍Business Valuation: Serves as a starting point in calculating a company's enterprise value.

Aligning Decisions to Outcomes that Improve EBITDA
To improve EBITDA, companies must align their decisions with strategies that enhance operational efficiency and profitability. This involves:

Cost Management: Reducing unnecessary expenses and improving cost-efficiency in operations. Streamlining processes, renegotiating supplier contracts, and optimizing resource allocation can significantly impact EBITDA.

Revenue Growth: Focusing on core business activities that drive revenue growth. This could involve:

• Expanding market reach and improving product or service offerings
• Enhancing customer satisfaction and retention
• Driving volume increases by maximizing operational efficiency

More effective utilization of existing people and assets to sell more volume with the same resources, thus growing revenue.

Investment in Technology: Leveraging technology to automate processes, improve productivity, and reduce operational costs. Implementing and using ERP systems like SAP to monitor and manage their operations more effectively.

Operational Excellence: Continuously improving business processes to enhance efficiency and productivity. This includes adopting best practices, training employees, and fostering a culture of continuous improvement.

Strategic Financing Decisions: Making informed decisions about financing that minimize interest expenses and optimize capital structure. This can help reduce the cost of debt and improve overall profitability.

By focusing on these areas, companies can make decisions that directly contribute to improving EBITDA, thereby enhancing their financial health and attractiveness to investors.

At Reveal our Transformations deliver strategic outcomes and business value in terms of revenue enablement, working capital optimization, improvements in operational efficiency, process change or adjustments, and governance enhancements that focus on longer-term sustainability which collectively have a positive impact on EBITDA. We will continue to share on this topic and others as they relate to the financial health of the organization.