March 10, 2023
For rookie retail shareholders, investing can seem like an alphabet soup of acronyms. One of the most prominent of these is EBITDA, short for earnings before interest, taxes, depreciation and amortization. Though many investing acronyms are insider baseball and not important for the individual investor, EBITDA is important because so many publicly traded companies use it to evaluate performance, for merger and acquisition valuation and executive compensation.
EBITDA is not a measure under generally accepted accounting principles (GAAP), but it remains a widely used metric in finance, especially to project a company’s long-term profitability and gauge its ability to repay future financing. It is also valuable to compare different companies and industries. EBITDA can help identify a company’s financial health and determine valuation.
The business metric was developed in the 1970s by John C. Malone, the former president and CEO of cable and media giant Tele-Communications. It gained prominence in the mid-1980s when a few CEOs felt that net income didn’t properly reflect ongoing earnings quality or expected cash flow because of interest charges and/or depreciation related to major capital expenditures. At the same time, investors were using leveraged buy-outs as a way to acquire businesses perceived to be undervalued.
While EBITDA has fallen out of favor a bit, its proponents argue that it offers a clearer reflection of operations by stripping out capital structure choices (debt versus equity financing), choices related to how an entity is taxed (pass through or entity level), or how management allocates the basis of acquired tangible and intangible assets to future periods (through depreciation and amortization), all of which can obscure how the company is really performing. EBITDA focuses only on operating expenses including cost of services/goods sold, sales and marketing expenses, and general and administrative expenses.
Like any financial measure, EBITDA has its shortcomings as well. While it does a good job measuring operational performance, it should not be used as an alternative measure for free cash flow. That’s because in some industries, the expenses that EBITDA excludes are critical expenses for the operation of the business, such as capital-intensive industries like manufacturing or shipping were depreciation is a major expense category since capital expenditure is necessary for maintaining and growing operations.
Today, according to Business News Daily, EBITDA is used mainly to do the following:
Bankers commonly use EBITDA to determine a company’s debt service coverage ratio (DSCR). This is a type of debt-to-income ratio, specifically used for business loans, meant to measure your cash flow and ability to pay.
Investors and business owners use EBITDA to compare companies within the same industry. The formula can also be used to standardize business performance against industry averages.
Give an overall view of performance.
EBITDA formula advocates say it provides a fairer view of how well a business is performing. For some companies, EBITDA provides a clearer picture of their long-term potential. Tech startups, for example, would prefer to use EBITDA to exclude the upfront business expense of developing sophisticated software when communicating with investors.
While the popularity of EBITDA falls in and out of favor, it remains a key metric used by those looking to acquire a company, investment bankers, financial analysts, accountants and retail shareholders in developing a perspective on company performance and profitability, an idea of a company’s cash flow potential, and a benchmark useful for evaluating and underwriting the risk of expected growth and performance.
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