What is EBITDA?

What is EBITDA?

In Rory’s piece yesterday about ‘The Rule of 40’, he mentioned that EBITDA is considered one of the best metrics to use in determining the health of a company. But what is EBITDA exactly and why is it important for investors to understand?

Strap yourself in folks, this is going to be a wild ride.

EBITDA is an acronym for earnings before interest, tax, depreciation, and amortization. Let’s break these down a little more:

Earnings is an obvious one for most of us — this is the amount of money a company has left over from its total sales (also known as revenue) once they subtract the cost of sales and other expenses. It’s also frequently referred to as net income. 

Interest is another easy one to understand — the money you owe from borrowing money. In this case, the interest typically relates to money that a company has borrowed in order to finance its activities. 

We all know about tax considering that we all have to pay it — even those big, publicly-listed companies (although the question over whether they pay enough tax is not as clear, especially here in Ireland).

On that point, the amount of tax a company has to pay will vary greatly depending on the different jurisdictions it sells products in and is headquartered in. Apple, for example, pays its taxes here in Ireland, but it also pays tax in the country where the sale of its products take place, as well as paying tax on any earnings it repatriates back to the U.S.

Now we’re getting into the sexy stuff — depreciation and amortization

Both are accounting methods used to calculate the cost of a company’s assets over time. Depreciation is the expensing of a fixed, tangible asset over its useful life, like property, machinery, or equipment. Amortization is the practice of spreading an intangible asset's cost over its useful life, like patents, trademarks or franchise agreements.

If we consider that a lot of assets — tangible or intangible — are usually quite expensive for a company, we can understand why they use methods like this to spread the cost over a number of years rather than realizing the entire cost of the asset in one year.  The practice of depreciation and amortization also links back to the tax bill a company has to pay as the expense amounts can be used as a tax deduction.

Of course, when we’re talking about EBITDA, it’s important to remember that we’re looking at an earnings figure that excludes all of the above. So why do we exclude them?

Well, many financial analysts believe that the effects of interest, taxes, depreciation, and amortization on a company’s bottom line are not reflective of the company’s current health. By stripping out the influence of these financial and regulatory impacts, we arguably get a more accurate picture of a company’s capacity to turn a profit.

However, it’s important to note that the EBITDA metric does not fall under the guidelines of another acronym you’ll often encounter in company earnings reports — GAAP, or generally accepted account principles. This is a common set of accounting principles, standards, and procedures issued by the Financial Accounting Standards Board (FASB) that public companies in the United States must follow.

Quite often companies will report both GAAP and non-GAAP figures for their earnings. If you’re struggling to figure out why companies would report both, the following tweet should explain better than I ever could:

 

In any case, EBITDA certainly has its uses, especially in figuring out things like profitability trends. However, if you notice that a company has suddenly started reporting EBITDA more prominently than it ever has before, it might be worth doing a bit of digging to see if they’re hiding anything like rising costs or more debt. 

If you want to catch up on any of the other terms you’ll frequently see when analyzing quarterly reports, don’t forget to check out our cheat sheet here.

JamesJames

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