EBITDA

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EBITDA, is earnings before interest, taxes, depreciation, and amortization

EBITDA, which stands for "Earnings Before Interest, Taxes, Depreciation, and Amortization", is a way of evaluating a company's profitability which excludes items that make comparisons across companies difficult and which are viewed as not central to the company's core operations.

Used as a proxy for the company's profitability and general financial performance, EBITDA can be calculated using data from a company's income statement.

EBITDA differs from operating cash flow by excluding payments for taxes or interest as well as capital expenditures and depreciation. EBITDA also differs from free cash flow because it excludes cash requirements for replacing capital assets (capex). EBITDA is used when evaluating a company's ability to earn a profit, and it is often used in stock analysis.

EBITDA is not defined according to Generally Accepted Accounting Principles (GAAP), a standard set of guidelines for financial accounting that regulate the preparation of financial statements. As such, a company is free to calculate its EBITDA however it wishes to, and many companies change the components of their EBITDA calculations from one reporting period to the next.

Wikinvest Calculation

EBITDA is calculated as follows on wikinvest:

EBITDA = Income before taxes + Interest Expense + Depreciation + Amortization

EBITDA calculations may vary in value depending on how depreciation and amortization are calculated. The rate of depreciation and what is considered depreciation can differ across different financial services. Amortization can also vary depending on considerations. this is exactly what i am adding to this report

Reasons to use EBITDA

  • For companies in industries which require big upfront investments or infrastructure (such as cable companies) and long gestation periods, EBITDA can be a more appropriate measure of the business's underlying profit potential since it excludes the cost of these investments.
  • EBITDA can indicate how attractive a leveraged buyout candidate the firm would be. In LBOs, the key factor is cash generated by the firm prior to discretionary expenditures, as it's this cash the buyer will use to pay off the loans he or she used to purchase the company, and EBITDA is the measure of cash flows from operations that can be used to support debt payment at least in the short term.
  • Looking at cashflows prior to capital expenditures may provide a better estimate of 'optimal value', as the capital expenditures may be unwise or earn substandard returns.
  • By looking at cashflows to the firm (prior to debt payments) it allows for comparisons across firms with different financial leverage.

Criticisms of EBITDA as a measure of profitability

Criticisms of using EBITDA as a measure of profitability generally refer to the fact that depreciation, interest, taxes, etc. are no less "real" than other expenses and it's therefore misguided to exclude them. For example, Warren Buffett levied the following criticism of EBITDA in letters to shareholders:

"References to EBITDA make us shudder — does management think the tooth fairy pays for capital expenditures? We're very suspicious of accounting methodology that is vague or unclear, since too often that means management wishes to hide something." [1]

"Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a "non-cash" charge. That's nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a "non-cash" expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?" [2]

References

  1. Warren Buffet's 2000 letter to shareholders
  2. Warren Buffet's 2002 letter to shareholders
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