Here we offer an overview of the concept of EBITDA, including its meaning, calculation methods and use cases in financial decision making.
What is EBITDA and why it is used?
“A business in your industry is normally valued at 3 times EBITDA”
“The bank won’t give you a loan with repayments more than 1.5 times EBITDA”
What exactly is EBITDA? Why do bankers, accountants and the like use it to compare businesses?
EBITDA Definition
Below is a literal definition of EBITDA, breaking down each part of the acronym:
E is for Earnings
This is profit showing on the Profit and Loss report. I guess PBITDA isn’t as snappy so earnings is used, however we could just as easily say profit.
B is for Before
We need to know which Earnings (profit) to use. “Before” is defining saying all the items that aren’t included in the profit. For example, Profit before Tax would mean the profit before tax was taken off. Earnings (profit) before ITDA is profit before all the items that are in ITDA are taken off.
I is for Interest
This is interest on any loans, overdraft, hire purchase or similar. Often this is shown as a separate line in the Profit and Loss account. If you receive interest then net it off any interest paid. We are looking for the profit unaffected by any effect of interest.
T is for Tax
As in corporation tax. This is the tax paid on profits (or it could be a reclaim for Research and Development tax credits). Ignore any other taxes such as PAYE or VAT which are part of normal trading, this relates just to tax on profits.
D is for Depreciation
Depreciation is the amount charged to write off the cost of fixed assets such as property, machinery and equipment over a period of time. This is the accounting treatment so it might be for example saying a £10,000 machine is charged at £2000 a year over 5 years. The main thing to note here is that it is not a cash movement, it is an accounting charge.
A is for Amortisation
Amortisation is very similar to Depreciation but relates to what are known as intangible assets, such as software or goodwill value created when a business was acquired. In accounts, amortisation and depreciation are noted separately.
You can normally physically kick fixed assets, which are depreciated, and can’t kick intangibles, which are amortised, but both are similar accounting charges to write off the value each year. Amortisation can be included with depreciation as the treatment is very similar and not many businesses have amortisation.
So what does the definition of EBITDA tell us?
We now have the profit of a company with the interest, tax and depreciation added back. Why?
Adding these items back to the profit is a way to determine the underlying performance of a business.
Interest results from any debt or other borrowing that the company has. Removing this impact from the profit effectively shows what the profit would be on a debt-free basis.
Different businesses will have access to different funds at different rates over different time periods. A business may have borrowed heavily and be spending significantly on loans compared to an identical business that has no debt. It’s not to say a business won’t need any debt, but seeing what its profit would be like without any debt gives an indication of what a reasonable level might be.
Adding back the tax shows the underlying profitability before any tax on that profit. Different companies experience different rates, for instance due to group structures, brought-forward losses or R&D tax credits.
Removing any variation of tax allows better comparisons between businesses. Think of it like trying to compare two employees’ salaries and taking net pay. It would be easier to compare if you were able to add PAYE, NI and pension back to get a better comparison of the true gross salary.
Depreciation, and amortisation, are not cash items. They can be significant costs within a company’s Profit and Loss account and are easy to identify. Taking them away leaves what generally are cash items. Wages, salaries, overheads, materials and income all have to be paid for from cashflow.
There will be some timing factors within these but as a guide the profit generated, excluding depreciation/amortisation, gives a reasonable indication of the cash generated by a business’ trading performance. It does not include any cash spent on investment in assets or other items.
Summary of EBITDA
Building these all together EBITDA gives us the underlying debt-free, tax-free cash generating trading performance of a business. This is the reason it is used as a guide for business valuations, to set banking covenant ratios and to compare businesses against each other.
Like many acronyms it is good to know what EBITDA stands for. It is even better to understand why it is being used.
©Steve Carroll 9 November 2020