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What is EBITDA? Description

EBITDA stands for earnings before interest, taxes, depreciation, and amortization. EBITDA came into wide use among private capital firms, wanting to calculate what they should pay for a business.

Calculation of EBITDA. Formula

      Net Sales

-     Operating Expenses


      Operating Profit (EBIT)

+    Depreciation Expenses

+    Amortization Expenses




The private capital firms that originally employed EBITDA as a useful valuation tool removed interest, taxes, depreciation, and amortization from their earnings calculations in order to replace them with their own presumably more precise numbers:

  • They removed Taxes and Interest because they wanted to substitute their own tax-rate calculations and the financing costs they expected under a new capital structure.
  • Amortization was excluded because it measured the cost of intangible assets acquired in some earlier period, including goodwill, rather than any current expenditure of cash.
  • Depreciation, an indirect and backward-looking measure of capital expenditure, was excluded and replaced with an estimate of future capital expenditure.

Later, many public companies, analysts and journalists have urged investors to also use EBITDA to measure the cash which public companies generate. EBITDA is often compared with cash flow, because it rightfully adds back to net income two major expense categories that have no impact on cash: depreciation and amortization.

Why EBITDA can be misleading

Yet EBITDA is a very poor and even misleading mechanism if it is used to approximate cash flows of public companies! Why?

  1. It excludes taxes and interest, which are real cash items and not at all optional. A company must of course pay its taxes and loans.
  2. It does not exclude all non-cash items. Only depreciation and amortization are excluded. Among the non-cash items not adjusted for in EBITDA are bad-debt allowances, inventory write-downs, and the cost of stock options granted.
  3. Unlike proper measurements of cash flow, EBITDA ignores changes in working capital. Additional investments in working capital consume cash.
  4. Finally, the main flaw of EBITDA is in the E (Earnings). If a public company has over- or under-reserved for warranty costs, or for restructuring expenses, or for bad-debt allowances, its earnings will be skewed. Its EBITDA will be misleading. If it has recognized revenue prematurely or disguised ordinary costs as capital investments, its reports are suspect. If it has inflated revenue through round-trip asset trades, the E is of no informational value.

Book: Steven M. Bragg - Business Ratios and Formulas : A Comprehensive Guide

Book: Ciaran Walsh - Key Management Ratios

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EBITDA growing in Europe
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Expert Tips

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