You may have found the acronym on a company income statement, but what is EBITDA? Business Advice expert Rob Drury explains what it stands for and what value it could give to your business.
What is EBITDA?
First things first, what does EBITDA actually stand for? The answer is “Earnings before Interest, Tax, Depreciation and Amortization.” Let’s break this down into a few different pieces.
What do we mean by earnings, interest and tax?
All found on the business’ income statement, these are the most straightforward of the factors that are included when considering what is EBITDA. They cover the profit you’ve made, the interest you’ve paid on any loans or forms of credit that you might have, and the taxes you’ve paid.
What do we mean by depreciation?
Now we’re getting into more technical accountancy language, with depreciation covering the drop-in value that has happened to any tangible, physical assets that you own as a business owner.
For example, if you had a large piece of machinery which cost £10,000 when you bought it, at the end of year one it will be worth a bit less, year two a bit less, year three even less, and so on. The rate of this reduction is the level of depreciation that you’ll be including in any EBITDA calculation.
What do we mean by amortisation?
The final element is amortisation, which is similar to depreciation except it covers intangible assets, such as copyrights or patents.
For example, if you own a copyright and this will last for twenty years and is worth £100,000 on day one, then each year over the course of the copyright it becomes less valuable and its value is amortised as its worth reduces.
What does it all mean when taken together?
The most straightforward calculation of EBITDA is:
EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortization
As with many things, there are different views on the value of EBITDA. There are also some who criticise the approach for having too much subjective judgement on what is and isn’t included within the calculation, which over time makes determining a trend quite challenging.
In 2011, Forbes ran an article titled ‘Top five reasons why EBITDA is a great big lie’, in which the magazine criticises EBITDA as a performance measure for making asset heavy companies look healthier, ignoring working capital requirements, and not adhering to generally accepted accounting practices, amongst other things.
Before that, CEO of Berkshire Hathaway Warren Buffett – who is considered to be one of the most successful investors of all time – said “It amazes me how widespread the use of EBITDA has become. People try to dress up financial statements with it.
“We won’t buy into companies where someone’s talking about EBITDA. If you look at all companies, and split them into companies that use EBITDA as a metric and those that don’t, I suspect you’ll find a lot more fraud in the former group.”
Despite its critics, many find EBITDA useful for comparing business against business, and industry against industry. As a method of financial analysis, it removes the effects of how companies go about their financing or accounting practices and provides a view of the earning potential of a business.
It’s by no means a perfect analysis tool, but EBITDA can give an indication of how one business’ profitability might compare against another. Just don’t use it in isolation!
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