The EBITDA Myth (The D and A Make a Difference)

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EBIT and EBITDA are two of the many metrics used to help analyze a company’s financial performance and profitability. The similarities and differences in their calculations lead to varied results.

The Difference Between EBIT and EBITDA

EBIT refers to Earnings Before Interest and Taxes, whereas EBITDA is the acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization.

The formulae to calculate EBIT and EBITDA are:

EBIT = Net Income + Interest Expense + Tax Expense

EBITDA = Net Income + Interest + Taxes + Depreciation Expense + Amortization Expense

The difference between EBIT and EBITDA is that Depreciation and Amortization are not added back to Earnings in EBIT, whereas they are added back to EBITDA.

EBIT is easier to calculate on the income statement by starting with Earnings Before Tax and adding Interest Expenses back to the figure.

EBITDA is difficult to calculate on an income statement. Besides adding Interest Expenses, Depreciation Expenses and Amortization Expenses should also be added back to Earnings Before Tax. But they are scattered in several spots in the income statement and may be challenging to identify. For example, Interest Expenses and Depreciation Expenses could be a part of general and administrative expenses or be hidden in the cost of goods sold. An easier way to identify them is to check the cash flow statement where depreciation and amortization numbers are fully broken out.

When to use EBIT and when to use EBITDA?

EBITDA can be a good proxy for cash flow for companies or industries that require relatively low capital expenditures to maintain operation. However, it’s not a useful metric for capital-intensive industries like infrastructure, oil, gas, mining, etc. In such cases, EBITDA and cash flow are often very far apart due to the extensive capital spending requirement. Since depreciation and amortization represent a section of historical capital expenditures, EBIT becomes a more appropriate metric.

EBITDA can be used to compare the operating performance of two companies having different fixed asset amounts, as it does not capture depreciation. Companies with high fixed asset amounts often have higher depreciation and lower EBIT than firms with lower fixed asset amounts. So, in such cases, EBITDA is a better metric than EBIT because it compares apples to apples.

Another way of calculating EBITDA is taking operating income and adding back depreciation and amortization. However, each formula for EBITDA can give a different profit number. The sale of a large piece of equipment or investment profits could explain the difference between the two EBITDA calculations. However, if you do not specify that inclusion explicitly, the EBITDA figure can be misleading.

The Impact of EBITDA on Business Valuation

EBITDA metrics to value capital-intensive industries are misleading because they have high depreciation expenses and capital requirements. Therefore, they usually trade at very low EBITDA multiples. What appears to be an undervalued company due to EBITDA is not, leading to a value trap for the inexperienced.

The EBIT metric is more appropriate for comparing companies across different industries because EBIT multiples are always higher than EBITDA multiples. Know the industry you are dealing with and the most appropriate and commonly used metrics for it.

EBITDA is not even relevant for intrinsic value analysis like financial modeling. Instead, free cash flow is a much more suitable metric when valuing a business.

Related: The Income Approach.

Is EBITDA a Myth?

Even though EBITDA is one of the important metrics in analyzing a company’s financial performance, some experts consider it a myth, a delusion. So, what makes them challenge EBITDA?

EBITDA does not consider depreciation and amortization, making asset-heavy companies look healthier. A company’s asset depreciation amount indicates its past spending on capital expenditures. Not considering depreciation and amortization blinds the observer to the company’s future asset replacement needs, both short and long term. As Warren Buffet said, “Does management think the tooth fairy pays for capital expenditures?”

EBITDA does not accurately reflect the company’s debt servicing ability. EBITDA reflects the ability of a company to service its debt, but only for some types of debt. It does show how much debt a company can handle, but that amount depends on which spot the creditor happens to occupy in the debt structure.

Suppose the calculation says that a Company XYZ will generate $10 million in EBITDA this year but does not reveal the company will make interest payments of $12 million on its secured debt between now and then. Therefore, simple math shows that the company has a $2 million cash shortfall. Unless you’re the secured lender and the EBITDA number is more than your debt amount for the same period, EBITDA does not reassure anyone of anything.

EBITDA ignores working capital requirements. As EBITDA does not consider working capital requirements–even if it is positive–the company will likely face a cash crunch to meet its working capital requirements. For example, a retail store needs cash to start ordering and building up inventory for the holiday season. Therefore, the retail store may borrow more cash and increase debt service costs or use its available cash by stretching payables. Irrespective of what the retail store chooses to do, EBITDA does not reflect changes in working capital requirements, which lands this business in trouble.

EBITDA calculations do not conform to GAAP. Generally accepted accounting principles (GAAP) are a set of common accounting principles, standards, and procedures that public companies in the United States follow when their accountants compile their financial statements.

It is easy to manipulate EBITDA numbers and make a company look like what it’s not. By inflating revenues by taking out interest, taxes, depreciation, and amortization expenses, accountants can make any company look great. For example, a business running warehousing operations will have one thing in abundance: rent. Suppose it reports in EBITDA, meaning it excludes its most significant operating expense. In that case, it chooses to inflate cash artificially and does not show the actual state of the company’s financial performance and profitability.

The Takeaway: Use EBITDA… in Context

EBITDA is not a single indicator of business value, nor does it exist in a vacuum. It has earned a bad reputation mainly due to improper use or overuse. It cannot be used as a standalone tool for measuring the profitability of a business. It is essential to use multiple metrics and consider several measures to arrive at a reliable result.

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Makalyn Feaster

Makalyn Feaster

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