EBITDA tends to play a significant role when it comes to gauging a company’s financial success. Even though it cannot be considered a potent parameter to measure a company’s overall profitability, it is a reliable indicator of a business’s operating performance.
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What is EBITDA?
Earnings before interest, taxes, depreciation, and amortization is a financial metric. Companies use it extensively to compute their business’ performance in terms of finances. EBITDA is also often used as an alternative to net income.
Furthermore, it offers a distinct idea to the investors and lenders about the profitability and of a company. However, It is often deemed to be misleading as it does not reflect the cash flow of the company.
EBITDA as a Financial Metric
It shows a company’s financial performance without taking into account its capital investments, including plant, property and equipment. It also does not account for expenses related to debt and emphasizes more on the firm’s operating decisions.
All these reasons highlight why it may not be an accurate measure of profitability. Additionally, it is often used to conceal poor financial judgment like availing a high-interest loan or using fast depreciating equipment that comes with a high replacement cost.
Nevertheless, it is still considered to be an important financial metric. EBITDA offers a precise idea of a company’s earnings before financial deductions are made, or how accounts are adjusted.
How is EBITDA Calculated?
It is mostly calculated by subtracting a company’s expenses other than interest, taxes, depreciation and amortization from its net income.
Typically, there are two formulas that can be used for calculating.
- EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortization
- EBITDA = Operating Income + Depreciation + Amortization
Companies implement these formulas to find out a specific aspect of their business effectively. Being a non-GAAP computation, one can select which expense they want to add to the net income.
For instance, if an investor wants to check how a company’s financial standing can be affected by debt, they can exclude only the depreciation and the taxes.
Example of EBITDA Calculation
This excerpt from Asian Paints Income Statement as on 30th March 2019 can be illustrated as an EBITDA example.
|Cost of revenue||11,49,88,200|
|Selling, general and administrative expenses||1,07,99,400|
|Income from operations||2,21,19,100|
As per Cash Flow Statement, depreciation and amortization of the company stood at Rs.43,06,700.
Earnings before interest, taxes, depreciation and amortization do not consider income tax and interest. So the EBITDA of Asian Paints for the Financial Year 2018-2019 would be,
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
= Rs (21594900+510000+10988200+4306700)
Notably, even the slightest mistake in the values of these components would impact a firm’s profitability significantly. To avoid the same, special care must be taken to keep finances up-to-date and to use a reliable accounting system.
One can judge if a company’s it is favourable or not by simply calculating the EBITDA margin.
What is EBITDA Margin?
EBITDA margin describes the relation between a firm’s aggregate earnings and total revenue. The said margin is said to indicate how much cash profit a firm can generate in a year. Furthermore, it comes in handy while comparing a firm’s performance to its contemporaries in a specific industry.
However, it is not registered in a company’s financial statement; so investors and financial analysts are required to calculate it on their own.
It is calculated using this formula below –
EBITDA Margin = EBITDA / Aggregate Revenue
Notably, a firm with a relatively larger margin is more likely to be considered a company with significant growth potential by professional buyers.
For instance, the EBITDA of ABC Private Limited is ascertained to be Rs.600,000 while their aggregate revenue is Rs.6,000,000. On the other hand, XYZ Private Limited registered Rs.750,000 as EBITDA and Rs.9000,000 as their aggregate revenue.
So as per the formula,
EBITDA margin for ABC Private Limited = EBITDA / Total Revenue
EBITDA margin for XYZ Private Limited = 750000/9000000
Therefore, despite having a higher EBITDA, XYZ Private Limited has a lower EBITDA margin when compared to ABC Private limited. It means ABC Private Limited is financially more efficient and hence more likely to be favoured by potential investors.
The EBITDA-to-interest coverage ratio is a financial metric which is used to assess a firm’s financial capability. It examines if the pre-tax income would be enough to pay off the firm’s interest-oriented expenses.
The EBITDA coverage ratio formula is expressed as –
EBITDA coverage ratio = (EBITDA + Lease Payments)/ (Interest Payments + Principal Payments + Lease Payments)
If the outcome is greater than 1 or 1, it suggests that the firm in question is financially in a sound position. Furthermore, it suggests that the firm is capable of repaying its liabilities.
It must be noted that there is a fundamental difference between EBITDA-to-interest coverage ratio and EBITDA coverage. For instance, the interest coverage ratio uses earnings before income and taxes, while the latter uses a more encompassing EBITDA.
EBITDA versus Net Income
In the general sense, It is considered as an indicator of a company’s capability to sustain its profitability. It helps to analyze a company’s operating profit and overall performance in the same. On the other hand, net income tends to highlight a company’s aggregate earnings.
Net income helps to find out a firm’s earnings per share, whereas, It come in handy for determining the overall earning potential of the company.
These pointers highlight its major advantages in brief.
- It offers a reliable overview of the business’s growth and effectiveness of its operational model.
- The risk of variables that often affect financial variables, including capital investment, is significantly reduced.
- It shows the actual value of a company’s cash flow which is generated through active operations.
- EBITDA only accounts for those expenses which are required to keep a firm’s day-to-day operations running.
- It helps to compare a firm’s financial efficiency against its contemporaries.
- It indicates a company’s appeal as a candidate for leveraged buyouts.
- The company’s debt does not get transferred during its sale and therefore, how a firm has been financed is usually not taken into account.
The drawbacks of EBITDA are given as follows –
- Due to the fact that debt expenses are excluded from EBITDA, the resulting figure is considered to be misleading. It does not disclose the information value of a company’s actual earnings or liquid assets.
- Many business owners use it to mask their poor financial judgment and finance-oriented shortcomings.
- It is not affecting high-interest financial debt.
- It does not register depreciation and EBITDA amortization as a real expense while gauging a firm’s financial performance.
- Companies are required to use other financial metrics along with EBITDA to arrive at a more accurate financial picture.
Hence, It is an efficient way of measuring the core profit trends of a firm as it has extraneous factors. Nonetheless, to arrive at a more comprehensive financial analysis, both investors and firm owners need to use other, more encompassing financial metrics.