What the EBITDA?

Understanding the oft-forgotten metric to frame company profitability.

Making a great first impression is one of the most fundamental factors in something becoming memorable. Without a magnetizing or glamorous introduction to something, people will often forget or have vague memories of it at most. This is especially true regarding complex subjects such as accounting terminology.

Many individuals were introduced to accounting and finance in university or college - typically in large, overcrowded auditoriums with poor lighting and sometimes with monotoned professors reading oversized textbooks in what sounded like another language. This is not the recipe for teaching something memorable, and most students walked out of their Accounting 101 class, retaining little and never looking back. This has led to a lack of financial literacy for many - but it doesn’t mean that it can never be achieved; with motivation, curiosity to learn, and some memorable moments to forge their journey, anyone can become financially literate. Terms like EBITDA might not have stuck before - but hopefully, with a re-introduction - the oft-forgotten metric will not be overlooked anymore.

The purpose of this article is to provide a memorable re-introduction to EBITDA to further the reader’s financial intelligence. The term will be explained at a high level and then broken down more profoundly before explaining its role in the grand scheme of the financial statements.

The culprit that causes EBITDA to be easily forgotten is likely the name. It’s not an overly catchy acronym, and when said aloud, some unknowingly drop the ‘T’ or the ‘D’ from the word confusing for those unfamiliar with the term. However, once the term is uncovered and understood, it should never be forgotten due to its ability to showcase profit through another lens than the Net Income.

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization and is used as an alternative metric to view company profitability by stripping away the interest, taxes, depreciation, and amortization expenses from the bottom line. It’s eerily similar to the Net Income besides those four components considered part of the company’s capital structure. The EBITDA can be most easily calculated by adding interest, taxes, depreciation, and amortization to the Net Income. It can also be calculated by finding the operating income - subtracting the cost of goods sold and operating expenses from the company’s revenue for a specific period - and adding the period’s depreciation and amortization. There are other means to calculate the metric, but it always boils down to the Income Statement.

After explaining the high-level calculation and meaning of the metric, it’s time to explore why those specific items are excluded from the EBITDA and where they come from. EBITDA attempts to give a clear picture of a company's profitability and aims to remove the uncontrollable factors that can significantly impact the Net Income. Interest, taxes, depreciation, and amortization aren’t directly related to the company’s profit generation. However, a company’s management decisions can dictate these factors’ effect on the bottom line. Interest, taxes, depreciation, and amortization are more related to the company’s capital structure than other factors used in calculating the net income - revenue, COGS, and operating expenses - which are all more closely associated with the product.

Interest is related to the company’s financing structure and can vary depending on its need for loans or other borrowed money to assist its operating activities. The more a company borrows, the more interest it’ll be required to pay back, and companies should be careful when borrowing. To garner a greater sense of a company’s operating performance relative to a similarly-sized, stage, and industry competitor with an entirely different combination of loans, grants, equity, and debt - it makes sense to add interest back to the Net Income to understand if they are generating similar amounts of profit or not.

Taxes are more straightforward and depend on the location(s) and tax laws wherever a business operates. Thus, adding taxes back to the Net Income makes sense when comparing similar companies’ profit generation abilities operating in entirely different jurisdictions.

Finally, depreciation and amortization are related to reducing the value of a company’s tangible and intangible assets over their useful life. These investments can be long-term and are not always made in the exact period that an analyst might be looking at a company’s operating performance. Therefore, to get a clearer sense of the operating performance, the depreciation and amortization are added back to the Net Income as it can distort the performance for that period if the company has a lot of long-term assets.

All three factors are similar in that they can be uncontrollable and distort the company’s profitability. Adding them back to the Net Income is a great way to compare companies based on their ability to create profits quickly. Knowing why a company wants to calculate the EBITDA is equally critical to understanding its usefulness. As mentioned, the EBITDA is another way of showing corporate profitability, but why does a company need another way to show this since that’s the purpose of the Net Income? This does not downplay the importance of the Net Income - but indicates that EBITDA is a valuable tool that can be utilized to compare and evaluate companies.

This article isn’t trying to persuade readers to abandon the Net Income when they need to quickly see a company’s profitability. It aims to get the reader to remember EBIDTA moving forward, know its usefulness, and when is the appropriate time to utilize the metric. None of these financial metrics are perfect - nothing is after all - that’s why it’s critical to use more than one to form an opinion - just like any great student would refer to multiple research papers to formulate their conclusion on a topic.

‍