What is EBITDA?
EBITDA, or “Earnings Before Interest, Taxes, Depreciation, and Amortization,” is the normalized, pre-tax cash flow generated by the core operations of a company.
- EBITDA is an acronym that stands for “Earnings Before Interest, Taxes, Depreciation, and Amortization.”
- EBITDA, stated in simple terms, measures a company’s core operating performance since only the pre-tax cash flow generated by its core business activities is factored in.
- The formula to calculate EBITDA is operating income (EBIT) plus non-cash add-backs, namely the depreciation and amortization (D&A) expense.
- EBITDA is a non-GAAP measure, yet arguably the most important metric in finance because of its comparability, where the profitability of different companies can be analyzed side-by-side because EBITDA is unaffected by discretionary decisions.
How to Calculate EBITDA?
EBITDA stands for “Earnings Before Interest, Taxes, Depreciation, and Amortization” and represents the operating profits generated by a company’s core business activities, expressed on a normalized basis.
Simply put, EBITDA measures the operating performance of a business in the particular context of its core operation’s capacity to generate consistent, recurring cash flows.
The calculation of EBITDA deliberately excludes non-cash items, namely depreciation and amortization, since the recognition of those expenses on the income statement prepared under U.S. GAAP is meant to abide by accrual accounting reporting standards.
Hence, the depreciation and amortization expense (D&A) – each accrual accounting convention – are treated as non-cash add-backs on the cash flow statement (CFS).
- Depreciation → The depreciation expense is embedded within the cost of goods sold (COGS) or operating expenses line item on the income statement. The recognition of depreciation reduces the carrying value of a company’s tangible fixed assets, or property, plant & equipment (PP&E), over its useful life, which is assumed to be in excess of twelve months.
- Amortization → The amortization expense is virtually identical to the concept of depreciation. The distinction is that the amortization expense causes an incremental reduction in the carrying value of a company’s intangible assets.
Since EBITDA is a non-GAAP measure, there is no standardized, consistent set of rules dictating the specific items that belong in the formula. However, the most common formulas used to calculate the EBITDA metric are as follows.
The term “normalized operating expenses” refers to a company’s operating expenses, such as selling, general and administrative (SG&A) costs and research and development (R&D), but excludes non-cash expenses like depreciation and amortization (D&A).
If the starting point is net income, i.e. the “bottom line” of the income statement, the steps to calculate EBITDA would involve adding interest, taxes, and non-cash items.
The widespread usage of the metric is primarily due to the metric being capital structure independent and unaffected by differences in taxes, which is jurisdiction-dependent and can be skewed by items such as net operating losses (NOLs).
What is the Conceptual Meaning of EBITDA?
The conceptual meaning of EBITDA can be best described as the normalized operating earnings generated by a company’s core business activities while neglecting non-operating items, such as the effects of financing decisions and taxes.
The following chart explains the full-form components of the EBITDA formula in detail.
What are the Pros/Cons of EBITDA in Finance?
EBITDA frequently receives widespread criticism for showing an inaccurate and potentially misleading representation of a company’s actual cash flow profile.
- Capital Expenditures (Capex) → The source of criticism surrounding EBITDA is the lack of consideration towards capital expenditures (Capex). For most companies, Capex is a major, recurring cash outflow that is captured on the cash flow statement but the full expenditure does not directly appear on the income statement. Instead, the Capex spending is allocated across the useful life assumption of the fixed asset (in the form of D&A) because the purchased asset is anticipated to provide monetary benefits in excess of one year. While a negligible issue for certain companies, for others, the disconnect between EBITDA and free cash flow (FCF) can become substantial, especially for capital-intensive companies.
- Change in Net Working Capital (NWC) → The change in net working capital (NWC) refers to the increase or decrease in the operating current assets and liabilities belonging to a company. The change in NWC can have a significant impact on the free cash flow (FCF), yet the cash necessary to fund day-to-day operations is ignored by the EBITDA metric.
- GAAP vs. Non-GAAP Metric → Since EBITDA is a non-GAAP metric, the lack of standardization and the absence of consistency among which items should be included (or excluded) from EBITDA makes it necessary to question the rationale of each adjustment on its own.
Still, EBITDA is frequently used across all fields of corporate finance because of the ease of computing the metric (i.e. ”back of the envelope”), in spite of the negative criticism supporting the notion that EBITDA is a flawed measure of profitability.
The usage of the EBITDA profit measure is particularly common in corporate valuation and mergers and acquisitions (M&A), where the metric is frequently part of the offer price, i.e. the purchase price expressed in the form of a valuation multiple.
- Capital Structure Neutral → Since EBITDA removes the impact of one-time, extraordinary items and is considered a capital-structure neutral metric, comparisons among different companies are easier, i.e. closer to being “apples-to-apples”. The prevalence of EBITDA in valuation multiples is tied to the “unlevered” aspect of the metric, wherein the effects of financing and taxes are excluded. Irrespective of the capital structure of the company – i.e. the reliance on debt or equity to fund day-to-day operations and purchases – comparisons among companies with different capitalizations are still feasible.
- Non-Cash Add-Backs → The EBITDA metric, by virtue of being a non-GAAP metric, is adjusted to remove the effects of non-cash items, such as depreciation and amortization (D&A). In effect, the operating metric is not distorted by non-cash items that can be substantial for certain companies, such as those operating in capital-intensive sectors, e.g. manufacturing, industrials, and telecom.
- Non-Recurring Items → Often, non-recurring items (or “one-time events”) such as the impairment of inventory and property, plant, and equipment (PP&E) lead to write-downs and write-offs for bookkeeping purposes, which can affect a company’s GAAP-based financials in the absence of adjustments. Considering such events are non-recurring and non-operating expenses (or income), the removal of their effects would be rational for purposes of forecasting and peer comparisons.
What is a Good EBITDA?
The EBITDA profit metric by itself – i.e. as a standalone metric – does not offer much practical insight into either how much a business is worth or its recent financial performance.
Instead, a company’s EBITDA must be divided by its revenue in the corresponding period to arrive at the EBITDA margin, which is a standardized measure of profitability widely used across a broad range of industries.
The EBITDA margin answers the following question, “For each dollar of revenue generated, what percentage of it trickles down to EBITDA?”
The ratio between EBITDA and revenue, expressed as a percentage, can determine a company’s operational efficiency and capacity to produce sustainable profits over the long run.
- Historical Comparisons → Once expressed in percentage form, a company’s EBITDA margin can be compared to its historical periods to determine the trajectory of its latest performance (i.e. upward or downward trend).
- Industry Benchmarking → In addition, a company’s EBITDA margin can be used for benchmarking purposes, wherein comparisons are made to its closest industry peers.
Therefore, there is no “good” EBITDA value, per se, without adequate context, such as the specific industry in which the company operates, the market size of the industry (i.e. potential revenue opportunity), and the company’s current placement in its overall lifecycle, at the very least.
Generally speaking, an EBITDA margin in excess of 10% tends to be viewed as “good,” while an EBITDA margin greater than 20% is perceived as “great.”
But even if all of the information and data points mentioned were collected, the norm is to avoid making direct comparisons of gross figures without standardizing the metric, i.e. the reliance on the EBITDA margin is the recommended approach, which is practically abided by the entire finance industry.
How to Forecast EBITDA?
Forming an opinion on the discretionary adjustments to EBITDA not only reduces the risk of inflating the metric but also improves the forecasting of EBITDA.
There are two methods by which EBITDA can be forecasted:
- Top-Down Bridge → The top-down approach begins with operating profit (EBIT) from the income statement and adds back D&A from the cash flow statement.
- Bottom-Up Bridge → On the other hand, the bottom-up approach starts with net income (i.e. the “bottom line”) and adds back taxes and the interest expense to arrive at EBIT, with the final step consisting of adding back D&A.
EBIT vs. EBITDA: What is the Difference?
EBITDA and EBIT are two pre-tax, capital-structure-neutral profit metrics with numerous commonalities.
- EBITDA → “Earnings Before Interest, Taxes, Depreciation and Amortization”
- EBIT → “Earnings Before Interest and Taxes”
However, EBIT (or “operating income”) is an accrual-accounting-based GAAP profit measure, whereas EBITDA is a non-GAAP, hybrid profit metric.
The exclusion of depreciation and amortization in the case of EBITDA (or inclusion for EBIT) is the primary differentiating factor between the two metrics, with the percent differential between the two metrics contingent on the industry (and company-specific).
In certain scenarios, the difference between the two will be marginal, whereas the difference can be “night and day” in other cases, e.g. capital-intensive companies with significant spending on capital expenditures (and thus depreciation).
- EBITDA → The operating expenses incurred by a company, except for non-cash items (D&A), are subtracted from revenue.
- EBIT → The operating expenses incurred by a company, except for non-cash items (D&A), are subtracted from revenue.
From a high-level perspective, the objective of presenting EBITDA is to offer investors a “normalized” view of financial performance.
The outcome, at least in theory, should portray a more accurate depiction of the company’s profitability, which sets the foundation for forecasting.
- GAAP Financial Measures → GAAP metrics such as operating income (EBIT) and net income strictly abide by the accrual accounting reporting standards.
- Non-GAAP Financial Measures → In practice, equity analysts and investors alike often pay more attention to non-GAAP metrics. Non-GAAP metrics are not reported on a company’s financial statements directly – i.e. EBITDA cannot appear on the income statement – yet companies still frequently present their non-GAAP metrics in management presentations and press releases, as well as mention them on earnings calls.
We’ll now move to a modeling exercise, which you can access by filling out the form below.
1. Income Statement Assumptions
Suppose a company generated $100 million in revenue for its latest fiscal year, 2021.
The operating costs incurred by the company were $25 million in COGS, $20 million in SG&A, and $10 million in R&D.
By subtracting COGS from revenue, we can calculate our company’s gross profit.
- Revenue = $100 million
- Cost of Goods Sold (COGS) = –$25 million
- Gross Profit = $100 million – $25 million = $75 million
The next profit metric to calculate is EBIT, which is equal to gross profit minus operating expenses, i.e. the SG&A and R&D expenses in our scenario.
- Selling, General and Administrative (SG&A) = –$20 million
- Research and Development (R&D) = –$10 million
- EBIT = $75 million – $20 million – $10 million = $45 million
From the operating income line, the next section is the non-operating income / (expense) section, where our only item is $5 million in interest expense.
If the interest expense is deducted from EBIT, we are left with earnings before taxes (EBIT), otherwise known as the pre-tax income.
- Interest Expense, net = –$5 million
- EBT = $45 million – $5 million = $40 million
Only one step is left before we reach our company’s net income, which is calculated by subtracting taxes from EBT.
Here, we’ll assume a tax rate of 20% and multiply that by our EBT, which comes out to $8 million in taxes
After subtracting the $8 million tax expense from our EBT, we can conclude that our company’s net income is $32 million.
- Taxes = –$8 million
- Net Income = $40 million – $8 million = $32 million
2. GAAP to Non-GAAP Reconciliation
Using the operating assumptions from earlier, our completed income statement is shown here.
In Excel, the bolded figures in the table will be calculations (i.e. black font color), whereas the non-bolded figures will be inputs (i.e. blue font color).
By abiding by the industry-standard formatting conventions, the chance of a mistake is reduced substantially and also makes the process of auditing financial models easier.
|Less: COGS||–$25 million|
|Gross Profit||$75 million|
|Less: R&D||–$20 million|
|Less: SG&A||–$10 million|
|Less: Interest, net||–$5 million|
|Less: Taxes||–$8 million|
|Net Income||$32 million|
But before we can reconcile EBITDA – either starting from revenue (“top-down) or net income (“bottom-up) – we’re missing one key assumption: the depreciation and amortization (D&A) expense.
If we assume the D&A expense recorded in 2021 is $5 million, what is the EBITDA of our hypothetical company?
- Depreciation and Amortization (D&A) = –$5 million
Note: The D&A expense is embedded within the COGS and operating expenses section of the income statement (and rarely broken out). Thus, the full value of the D&A expense should be obtained from the cash from operations (CFO) section of the cash flow statement (CFS), where each expense is treated as a non-cash add-back.
3. EBITDA Calculation Example (Top-Down Bridge)
Our next section is comprised of two parts, where we’ll calculate the EBITDA of our hypothetical company using the income statement built in the previous section.
Under the “top-down” approach, we’ll start by linking to EBIT from our income statement and adding back the $5 million in D&A, which equals $50 million in EBITDA.
By dividing our company’s EBITDA by revenue, the EBITDA margin is 50.0%.
- EBITDA = $45 million + $5 million = $50 million
- EBITDA Margin (%) = $50 million ÷ $100 million = 50.0%
4. EBITDA Calculation Analysis (Bottom-Up Bridge)
In contrast, the “bottom-up” approach starts with net income, i.e. the profit metric inclusive of all operating and non-operating expenses found at the bottom of the income statement.
To calculate EBITDA from net income, we’ll add back taxes, interest expense, and D&A to arrive at an implied EBITDA of $50 million (and a margin of 50.0%), which confirms our prior calculation is, in fact, correct.
- EBITDA = $32 million + $8 million + $5 million + $5 million = $50 million
- EBITDA Margin (%) = $50 million ÷ $100 million = 50.0%