EBITDA is probably the most discussed and widely used financial analysis. It acts as a measure of overall financial performance and is issued throughout the finance sector as a tool for valuing businesses.
In this post, we will cover what EBITDA is, why it is so heavily relied upon by financial analysts, and how to use it as an analytical tool for evaluating businesses.
What Is EBITDA?
EBITDA is an acronym that stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is often used when performing profitability analysis and is often used as a basis for financial modeling.
One of the key characteristics of EBITDA is that it removes the impact of financing from net income. Interest expense can then be addressed.
Similarly, the calculation excludes the impact of non-cash expenses that artificially reduce net income. By stripping away these expenses, EBITDA becomes a more clear representation of a business’s performance as it depicts earnings before the impact of certain accounting policies.
Why EBITDA Is So Heavily Used In Finance
When businesses are analyzed as an investment, EBITDA is considered to more accurately reflect the performance of a business. By reducing the noise created by accounting policies, tax strategies, and capital structure, it provides a more clear idea of the ability of a business to generate profit.
One of the key reasons it is used as a metric for analyzing investments is that it provides a consistent and concise approach to analyzing the profits of multiple businesses across all industries.
Many proponents of EBITDA say that it provides a much better idea of profitability and growth trends when the cost of capital is removed from the picture. Ironically, EBITDA provides a good metric for gauging a business’s ability to service debt when examining a potential leveraged buyout (LBO).
Understanding EBITDA When Analyzing A Business
As we mentioned above, EBITDA is considered to be a more clear representation of a business’s ability to generate profit. However, when analyzing EBITDA it is important to understand its limitations and when using it is appropriate.
It is important to note that EBITDA is not recognized as a measure of financial performance under US GAAP. In fact, the calculation is not always static and some businesses may be liberal in what expenses they remove from EBITDA.
Another drawback to relying solely on EBITDA is that it can sometimes be used as a way to distract from larger issues that glare through in net income. One important behavior to watch out for is when a business begins to rely on EBITDA over net income when they have not done so in previous communications.
This sometimes occurs when a business has extended its borrowing or has experienced some increase in the cost of capital.
One important distinction to make is that EBITDA does not translate to cash earnings. This is a common misconception and it is important to understand that EBITDA ignores the cost of assets.
This is considered to be a major oversight as it basically makes the assumption that all net profit is a function of sales and operating expenses, which ignores the fact that a business relies on assets and financing to survive and grow.
Understanding How To Calculate EBITDA
The formula for EBITDA can be calculated forward or backward, meaning you can start with net income and move backward, or you can calculate it from gross profit going forward.
To calculate EBITDA starting with net income follow the below formula:
EBITDA = Net Income + Interest Expense + Tax Expense + Amortization Expense + Depreciation Expense
To calculate EBITDA moving forward follow the below formula:
EBITDA = Revenue – operating expenses – SG&A expense
Using Datarails, a Budgeting and Forecasting Solution
Datarails’ FP&A solution replaces spreadsheets with real-time data and integrates fragmented workbooks and data sources into one centralized location. This allows users to work in the comfort of Microsoft Excel with the support of a much more sophisticated data management system at their disposal.
Every finance department knows how tedious building a budget and forecast can be. Integrating cash flow forecasts with real-time data and up-to-date budgets is a powerful tool that makes forecasting cash easier, more efficient, and shifts the focus to cash analytics.
Regardless of the budgeting approach your organization adopts, it requires big data to ensure accuracy, timely execution, and of course, monitoring.
Datarails is an enhanced data management tool that can help your team create and monitor cash flow against budgets faster and more accurately than ever before.