What is EBITDA?
It stands for Earnings before Interest, Tax, Depreciation, and Amortization. When a company financial statements are prepared the margin and the number of EBITDA is the most talked line item in the income statement to judge the profitability of the business. It 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.
It 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
To calculate the EBITDA of the company we need to follow the following steps. Below is an example of the income statement of the company. And the components, which will give us a clear picture of what are the components.
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
- EBITDA = $2,000,000 – $1,000,000 – $500,000 – $25,000 – $75,000
- EBITDA = $400,000
Hence the component are revenue, operating expenses, salaries, rent, depreciation and amortization, and other direct and indirect expenses.
EBITDA = Revenue – Operating expenses – salaries – rent – amortization – depreciation
Alternatively, we can calculate 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 = EBIT + Depreciation and amortization + Interest expense
Examples / Calculation
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 EBITDA and the margin of the company for the fiscal year.
It 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 can be calculated as:
EBITDA = 1000 – 400 – 135 – 150 – 112
EBITDA = 203
EBITDA Margin = EBITDA / Revenue
EBITDA Margin = 203 / 1000
EBITDA Margin = 20.3%
The following are the advantages:
- This 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 it tells whether the business is able to recover all the expenses which it is incurring to generate the revenue. It is also used for internal management reporting and discussion and analysis.
- This also tells the management and the executive of the business how well it is generating the revenue to recover the cost incurred if the EBITDA of any business is negative then it becomes an alarming situation for the business to operate.
- 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 in a different manner and can have their separate definition.
- It is also misleading sometimes when financial annual reports have used different accounting principles to calculate it or to compute the cost components of their business, in that case, the companies under comparison don’t become alike hence EBIT is now widely been used these days.
- It 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 – What is EBITDA?
Hence, by just looking at the 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.
This has been a guide to EBITDA. Here we discussed the Advantages, Disadvantages, Limitation, Types, Components, and Examples. You can also go through our other suggested articles to learn more –