EBITDA

Overview of EBITDA

EBITDA stands for Earnings before Interest, Tax, Depreciation, and Amortization. When a company’s financial statements are prepared the EBITDA margin and the number of EBITDA is the most talked-about line item in the income statement to judge the profitability of the business. EBITDA refers to earnings for any business which comes solely from the operations of the business and it comes after gross profit and deduction of various overheads, selling, and distribution expenses.

EBITDA is simply computed by adding back the non-cash expense i.e. depreciation and amortization to the operating income of the company.

Types and Components of EBITDA

To calculate the (Earnings before Interest, Tax, Depreciation, and Amortization) of the company we need to follow the following steps. Below is an example of the income statement of the company. And the components of EBITDA will give us a clear picture that what are the components of EBITDA

In order to compute the EBITDA of the above company, we need to deduct all the operating and non-operating expenses of the company from the revenue.

Hence,

Revenue – Operating Expenses – Salaries – Rent – Amortization – Depreciation

By deducting this we can arrive at the EBITDA component

• EBITDA = $2,000,000 – $1,000,000 – $500,000 – $25,000 – $75,000
• EBITDA = $400,000

Hence the component of the EBITDA is revenue, operating expense, salaries, rent, depreciation and amortization, and other direct and indirect expenses.

EBITDA Formula

Alternatively, we can calculate (Earnings before Interest, Tax, Depreciation, and Amortization) backwards also by adding the interest and the non – cash expense component to EBT i.e. earnings before tax or PBT i.e. profit before tax

So the formula will be

Examples of EBITDA

Let’s take an example to understand the calculation of (Earnings before Interest, Tax, Depreciation, and Amortization) in a better manner.

Example #1

Company RMZ Corp prepares their income statements in accordance with the U.S. GAAP and the Income statement for the year 2003 – 2004 is given below. Calculate the (Earnings before Interest, Tax, Depreciation, and Amortization) and the EBITDA margin of the company for the fiscal year.

Solution:

(Earnings before Interest, Tax, Depreciation, and Amortization) can simply be calculated in this case by deducting all the direct and the indirect expenses that the business has incurred from the revenue that it has generated during that fiscal year. So that EBITDA can be calculated as

EBITDA is calculated as

•  = 1000 – 400 – 135 – 150 – 112
•  = 203

EBITDA Margin is calculated as

EBITDA Margin = EBITDA / Revenue

• = 203 / 1000
• = 20.3%

Advantages and Disadvantages of EBITDA

Below are some pros and cons of EBITDA as follows:

Advantages

The following are the advantages of EBITDA

• It is the most important line item of the business that is the reason it is widely used for financial analysis and peer group analysis
• It is the only line item which tells the analyst what the strength of the business and it tells whether the business is able to recover all the expense which it is incurring to generate the revenue. It is also used for internal management reporting and discussion and analysis
• It also tells the management and the executive of the business how well it is generating the revenue to recover the cost incurred if the (Earnings before Interest, Tax, Depreciation, and Amortization) of any business is negative then it becomes an alarming situation for the business to operate

Disadvantages

The following are the disadvantages of EBITDA

• It is widely used in valuation techniques especially when using the discounted cash flow method and it can also give misleading results at times because each company can report their Earnings before Interest, Tax, Depreciation, and Amortization in a different manner and can have their separate definition of Earnings before Interest, Tax, Depreciation, and Amortization
• Earnings before Interest, Tax, Depreciation, and Amortization is also misleading sometimes when financial annual reports have used different accounting principles to calculate the Earnings before Interest, Tax, Depreciation, and Amortization or to compute the cost components of their business, in that case, the Earnings before Interest, Tax, Depreciation, and Amortization of the companies under comparison doesn’t become alike hence EBIT is now widely been used these days

Limitations

• Earnings before Interest, Tax, Depreciation, and Amortization has a limitation that it does not account for changes in working capital. Liquidity fluctuates because of interest, taxes and capital expenditures
• Determine how difficult it would be to turn assets into cash. This could highlight low liquidity but for that, we have different liquidity measures and ratios

Conclusion

Hence, by just looking at the Earnings before Interest, Tax, Depreciation, and Amortization margin or the number the business should not judge the company’s financial strength and weakness. Detailed analysis of the profit line items of the company should be done in order to do a complete analysis and a good analysis.

Recommended Articles

This is a guide to EBITDA Example. Here we discuss types & components, examples along with Advantages and Disadvantages. You may also look at the following articles to learn more –

1. Financial Analysis Example
2. Purpose of Income Statement
3. Standard Deviation Examples
4. Equity Examples