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 byearnings, interest andtax?
All found on the business? income statement, these are the most’straightforward of the factorsthat 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 bydepreciation?
Now were 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 youll beincluding in any EBITDA calculation.
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 whocriticise the approach for having toomuch subjective judgement on what is and isnt 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 youll 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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