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. It refers to earnings for any business that comes solely from the business’s operations, and it comes after gross profit and deduction of various overheads, selling, and distribution expenses. It is simply computed by adding back the non-cash expense, i.e. depreciation and amortization, to the company’s operating income.
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
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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 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. First, 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.
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
Given below are the advantages and disadvantages mentioned:
Advantages:
- 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 that tells the analyst the strength of the business and whether the business can recover all the expenses, 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:
- 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 have a limitation: 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. Instead, a detailed analysis of the company’s profit line items should be done to complete and good analysis.
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