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 that 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 which will give us the 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 the 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
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- EBITDA = $2,000,000 – $1,000,000 – $500,000 – $25,000 – $75,000
- EBITDA = $400,000
Hence the component of the EBITDA are revenue, operating expense, salaries, rent, depreciation and amortization and other direct and indirect expenses.
EBITDA Formula
EBITDA = Revenue – Operating Expenses – Salaries – Rent – Amortization – Depreciation
Alternatively, we can calculate (Earnings before Interest, Tax, Depreciation, and Amortization) backward 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
EBITDA = EBT + Depreciation and Amortization + Interest Expense
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. Detail analysis of the profit line items of the company should be done in order to do a complete analysis and a good analysis.
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