EBITDA stands for “earnings before interest, taxes, depreciation and amortization.” It is a metric used to evaluate a company’s operating performance and is a broad measure of cash flow from the entire company’s operations.

Here’s how EBITDA works, why companies and investors use it and the drawbacks of using it.

The main components of EBITDA

EBITDA is a metric that is often used by companies, investors, lenders and others to evaluate the performance of a company. EBITDA removes the impact of debt financing, capital structure, depreciation, and taxes, in order to present the broadest measure of a company’s cash flow. In other words, it provides an idea of how much cash a business can generate before it has to pay various stakeholders such as lenders and the government and re-invest in its own business.

The main components of EBITDA are:

• Earnings: The category of earnings is the company’s total bottom line – its profit – after paying off all interest expenses, reinvesting in the business and paying suppliers.
• Interest: This is the cost of any money that the company has borrowed, for example through bonds.
• Taxes: Taxes are any costs associated with paying local, state and federal authorities on the profit generated by the business.
• Depreciation: Depreciation is the cost of the company’s fixed assets allocated over time. Assets depreciate over their lifecycle as they become obsolete.
• Amortization: Amortization is the cost of a fixed intangible asset over time. Intangible assets are things like a brand name or intellectual property.

So EBITDA takes earnings and then adds back each of the other elements, arriving at a broad measure of the company’s cash flow.

A company’s EBIT is also known as its operating earnings, which includes the expenses to run its business but not any associated financing costs (i.e. interest expense). So EBITDA can also be calculated by adding back depreciation and amortization expenses to operating income.

Why companies use EBITDA

EBITDA is used in a variety of ways by different stakeholders in a business, and it’s useful to have a common way to discuss the performance of a business:

• Lenders: Lenders may use EBITDA as a way to measure how much cash flow is available to service debt payments.
• Investors and stock analysts: These groups may use EBITDA as the basis of valuation measures such as enterprise value divided by EBITDA and also use it to see how indebted a company is. It also is used to compare companies with one another.
• Company managers: Managers may use EBITDA to understand how much cash flow they have available to make decisions about reinvestment, debt issuance and redemption and other capital allocation decisions.

However, EBITDA can be a deceptive tool and not representative of a company’s profitability.

The drawbacks of EBITDA

While EBITDA is often used in industry to take a reading on a company’s cash flow, it has some serious drawbacks and is often a bad proxy for cash flow.

EBITDA is not a generally accepted accounting principle (GAAP)

EBITDA is not officially recognized under GAAP and is not used as an official measurement by many companies. In practice, this means that companies may have different definitions of EBITDA and some may add back “one-time” expenses to the calculations, making them look more profitable than they actually are.

For example, EBITDA often includes “one-off” expenses that most people would consider operating expenses, such as one-time legal fees, stock-based executive compensation, and other employee expenses. As such, using EBITDA or “adjusted EBITDA” can make a company look more profitable than it really is.

EBITDA fails to consider financing

Some experts consider EBITDA to be a misleading metric because it does not take into account the company’s debt expenses. EBITDA measures a company’s performance before factoring in how it’s financed, so using this metric alone may provide a misleading view of the business.

For example, two companies may have the same EBITDA, but one uses much more debt financing than the other, resulting in a significantly higher interest expense. While they may have the same EBITDA, after-tax profits will be very different because of the debt.

EBITDA fails to consider tax impacts

As its name suggests, EBITDA does not account for tax expenses. So the metric does not include any amount of tax paid by the company, which can impact its profitability, of course.

EBITDA does not consider reinvestment

By adding back depreciation and amortization, the EBITDA calculation effectively fails to consider how a business needs to continually reinvest in fixed assets to keep its business competitive. While a business may be able to skimp on investments for a few years during lean times, it eventually has to reinvest in its assets in order to remain a going concern.

In addition, EBITDA can make companies in different industries look similarly profitable when they’re not. For example, industries such as manufacturing that require high reinvestment in fixed assets may not be accurately compared to “people-centric” businesses that don’t require such heavy reinvestment. By excluding the depreciation and amortization components of the calculation, EBITDA obscures the very different capital reinvestment needs of those companies.

Bottom line

EBITDA is a useful metric that can help investors and others gain valuable insights into a company’s performance. However, they must also be aware of EBITDA’s drawbacks to get a full picture of the company and look at EBITDA as part of the larger picture, including metrics such as free cash flow or operating cash flow, to understand a company’s profitability from all angles.