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EBITDA

Guide to Understanding EBITDA

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EBITDA

What Does EBITDA Stand For?

EBITDA, or “Earnings Before Interest, Taxes, Depreciation and Amortization”, is arguably the most important profit metric in finance.

Conceptually, EBITDA measures the operating performance of a company, in the particular context of its core operations generating consistent, recurring cash flows.

Stated in simple terms, the profit metric’s objective is to provide enhanced transparency into a company’s operating performance, with such non-GAAP measures presented as supplementary material.

The practice of companies disclosing non-GAAP earnings to offer more insight into their recent operational performance and financial position has become rather common in recent times.

Thus, EBITDA reflects a company’s core operating profits, i.e. revenue minus all operating expenses except for non-cash items, namely depreciation and amortization (D&A).

How to Calculate EBITDA (Step-by-Step)

Since the objective of the non-GAAP metric is to provide a “normalized” view of financial performance, the outcome should, at least in theory, result in more accurate projections.

  • 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.

The simplest method of computing EBITDA consists of adding depreciation and amortization (D&A) – the two most prevalent non-cash items – to a company’s operating income (EBIT).

EBITDA excludes non-cash expenses, namely depreciation and amortization, as the recognition of those items on the income statement is related to the accrual accounting reporting standards established under U.S. GAAP.

The term “D&A” stands for “depreciation and amortization”, respectively, and each represent a non-cash add-back on the statement of cash flows.

  1. Depreciation → The non-cash expense recognized on the income statement to reduce the carrying value of a company’s property, plant & equipment (PP&E) over its estimated useful life assumption.
  2. Amortization → Virtually identical to depreciation, the only distinction of amortization is that the incremental reduction is applied to the company’s intangible assets across its estimated useful life as opposed to its fixed assets.

EBITDA Formula

Since EBITDA is a non-GAAP measure, there is no consistent set of rules dictating the specific items that belong in the metric.

However, the most common formulas used to calculate the EBITDA metric are as follows.

EBITDA = Revenue Cost of Goods Sold (COGS) “Normalized” Operating Expenses
EBITDA = EBIT + Depreciation + Amortization
EBITDA = Net Income + Taxes + Interest Expense + Depreciation + Amortization

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.

EBIT = Net Income + Interest + Taxes
EBITDA = EBIT + Depreciation + Amortization

The widespread usage of the metric is largely 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).

EBITDA Formula: Full Form Components

Before we delve further into the EBITDA metric and our practice exercise tutorial in Excel, ensure each component in the formula is truly understood by reviewing the following table.

Components Description
Earnings
  • The “Earnings” component refers to the operating income (EBIT) that a company generates across a specified period.
  • EBIT is computed by subtracting the company’s operating costs (e.g. COGS, SG&A, R&D) from its net revenue in the corresponding period.
Interest
  • The “Interest” piece is comprised of two parts: interest expense and interest income.
    1. Interest Expense: The periodic interest payments owed to lenders as part of the financing arrangement over the borrowing term of the debt, i.e. the cost of debt financing (“cash outflow”)
    2. Interest Income: The earnings brought in from investing cash in fixed income securities, government bonds, marketable securities and more (“cash inflow”)
  • On the income statement, the two types of interest are often consolidated on a “net” basis, but regardless, both are non-operating expenses related to discretionary decisions by management (and are thus not representative of a company’s core operating performance).
  • Hence, neither interest expense nor interest income is deducted from EBITDA.
Taxes
  • The “Taxes” paid is a mandatory obligation attributable to all companies, whether publicly-traded or private, but the EBITDA metric deliberately ignores the tax expense.
  • Like interest, taxes are also a non-operating expense and are recorded below the operating income (EBIT) line item, meaning that the tax expense is not deducted in the calculation.
  • The intuition to neglect taxes is similar to the rationale for the treatment of interest. For instance, the tax rate at which the dollar amount of owed taxes is determined can differ based on the company’s jurisdiction and various company-specific factors can impact amount paid in a period such as net operating losses (NOLs), deferred taxes and tax credits.
Depreciation
  • The “Depreciation” concept in accrual accounting reduces the value of fixed assets (PP&E) across its useful life assumption, which is defined as the estimated number of years in which the asset is expected to continue providing economic benefits.
  • On the income statement, the annual depreciation is recorded as an expense but treated as an add-back on the cash flow statement (CFS) because it is a non-cash item, i.e. there was no real movement of cash.
  • Instead, depreciation is the allocation of the initial cash outlay associated with the capital expenditure (Capex), i.e. the purchase of the fixed asset (PP&E), over its useful life to effectively “smoothen” the recognition of the expenditure on the income statement and abide by the matching principle in accounting.
Amortization
  • The “Amortization” expense is near identical conceptually as depreciation, with the only distinction being that amortization is meant to incrementally reduce the value of intangible assets such as patents and copyright, rather than tangible assets like equipment and machinery.
  • Since depreciation and amortization represent non-cash items, yet are still recorded on the income statement per GAAP accounting standards, each are treated as add-backs to operating income (EBIT).
  • On the income statement, the D&A expense is rarely broken out in its own separate line item and is instead embedded within either cost of goods sold (COGS) or operating expenses. In order to obtain the entire depreciation and amortization expense of a company, refer to the cash flow statement (CFS), as the non-cash items will be added back to net income as part of the cash reconciliation.

Adjusted EBITDA: Examples of Add Backs

The process of calculating EBITDA, however, can become more intricate due to the treatment of items such as stock-based compensation (SBC), with the resulting figure termed “Adjusted EBITDA”.

The add-backs to determine a company’s adjusted EBITDA are discretionary, and some examples of such non-recurring adjustments include the following:

The treatment of stock-based compensation (SBC) – a non-cash item that creates additional dilution – is a rather complex subject discussed in more detail in the following post → Stock-Based Compensation in DCFs.

For a real-world example of a GAAP to non-GAAP reconciliation, see the adjustments by Twitter, Inc. (TWTR) in its most recent reporting period (Q-2, 2022) prior to its take-private transaction.

Twitter EBITDA Example (2022)

Twitter Announces Second Quarter 2022 Results (Source: TWTR Investor Relations)

Pros and Cons of EBITDA

EBITDA often receives criticism for showing an inaccurate and misleading representation of a company’s actual cash flows.

Criticism of EBITDA
Capital Expenditures (Capex)
  • The source of criticism surrounding EBITDA is namely 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 spend 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 changes in net working capital (NWC) is 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 in 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.

EBITDA, in spite of all the criticism, is still widely used because of the ease of calculating the metic (i.e. ”back of the envelope”).

In practice, usage of the EBITDA profit measure is particularly common in corporate valuation and mergers and acquisitions (M&A).

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”.

Benefits of EBITDA
Capital Structure Neutral 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 As part of the calculation, depreciation and amortization (D&A) is added back to remove its effects, so the metric is also not distorted by a non-cash expense that can be substantial for certain companies, such as those operating in capital-intensive sectors, e.g. manufacturing, industrials, and telecom.
Non-Recurring Items (”Normalization”) Often, one-time events such as inventory and property, plant and equipment (PP&E) impairments like write-downs and write-offs can affect a company’s financials. 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 insight into neither how much a business is worth nor its recent financial performance.

But a company’s EBITDA can 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.

EBITDA Margin (%) = EBITDA ÷ Revenue

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 that 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.

But even if all of those 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.

Learn More → Margins by Industry (Source: Damodaran)

Forecasting EBITDA: “Top-Down” vs. “Bottom-Up” Bridge

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 in which EBITDA can be forecasted:

  1. Top-Down Approach → The top-down approach begins with operating income (EBIT) from the income statement and adds back D&A from the cash flow statement.
  2. Bottom-Up → 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.
Top-Down EBITDA = Forecasted EBIT + Depreciation + Amortization
Bottom-Up EBITDA = Forecasted Net Income + Taxes + Interest Expense + D&A

EBIT vs. EBITDA: Non-GAAP Reconciliation

EBIT, or “operating income”, is an accrual-accounting-based GAAP profit measure, whereas EBITDA is a non-GAAP, hybrid profit metric.

EBITDA and EBIT are two pre-tax, capital-structure-neutral profit metrics that share numerous commonalities.

  • EBITDA → “Earnings Before Interest, Taxes, Depreciation and Amortization”
  • EBIT → “Earnings Before Interest and Taxes”

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 (i.e. capital-intensive companies with significant D&A).

  • 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.

EBITDA Calculator – Excel Model Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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Step 1. Income Statement Operating 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
  • 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.

  • SG&A = –$20 million
  • 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 = –$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 tax expense from EBT, we conclude that the net income of our company is $32 million.

  • Taxes = –$8 million
  • Net Income = $40 million – $8 million = $32 million

Step 2. Income Statement Build (U.S. GAAP)

Using the operating assumptions from the 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 unbolded figures will be inputs (i.e. blue font color).

Following the industry-standard formatting conventions reduce the chance of a mistake substantially and make financial models easier to audit.

Income Statement 2021A
Revenue $100 million
Less: COGS –$25 million
Gross Profit $75 million
Less: R&D –$20 million
Less: SG&A –$10 million
EBIT $45 million
Less: Interest, net –$5 million
EBT $40 million
Less: Taxes –$8 million
Net Income $32 million

Step 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.

But before we can calculate the metric, 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

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%.

  • EBITDA = $45 million + $5 million = $50 million
  • EBITDA Margin (%) = $50 million ÷ $100 million = 50%

Step 4. EBITDA Calculation Example (“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.

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%), which confirms our prior calculation is, in fact, correct.

  • EBITDA = $32 million + $8 million + $5 million + $5 million = $50 million

EBITDA Calculation

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