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2/19/2010 Earnings before interest, taxes, depreci

Earnings before interest, taxes, depreciation and


amortization
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(Redirected from EBITDA)

EBITDA ee-bit-dah is the acronym for Earnings before Accountancy


Interest, Taxes, Depreciation, and Amortization. It is a
non-GAAP metric that is measured exactly as stated. All
interest, tax, depreciation and amortization entries in the
Income Statement are reversed out from the bottom line Net
Income. It purports to measure cash earnings without accrual
accounting, canceling tax-jurisdiction effects, and canceling Key concepts
the effects of different capital structures. Accountant Bookkeeping Trial balance General

EBITDA differs from the operating cash flow in a cash flow ledger Debits and credits Cost of goods sold
statement primarily by excluding payments for taxes or Double-entry system Standard practices Cash
interest as well as changes in working capital. EBITDA also and accrual basis GAAP / IFRS
differs from free cash flow because it excludes cash
Financial statements
requirements for replacing capital assets (capex).
Balance sheet Income statement Cash flow
EBITDA Margin refers to EBITDA divided by total statement Equity Retained earnings
revenue. EBITDA margin measures the extent to which cash
operating expenses use up revenue. Auditing

Financial audit GAAS Internal audit Sarbanes


Oxley Act Big Four auditors
Contents Fields of accounting

1 Use by private equity investors Cost Financial Forensic Fund Management


2 Use by debtholders Tax
3 Use by shareholders
4 Unprofitable businesses
5 See also
6 References

Use by private equity investors


In the process of purchase, long-life assets will be revalued to market values. Their depreciation and amortization
will necessarily be changed. Control of the business allows the purchaser to move it to a new tax jurisdiction and to
refinance its debt.[citation needed]

Use by debtholders
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EBITDA is widely used in loan covenants. The theory is that it measures the cash earnings that can be used to pay
interest and repay the principal. Since interest is paid before income tax is calculated, the debtholder can ignore
taxes. They are not interested in whether the business can replace its assets when they wear out,therefore can
ignore capital amortization and depreciation.

There are two EBITDA metrics used.

1. The measure of a debt's pay-back period is Debt/EBITDA. The longer the payback period, the greater the
risk. The metric presumes that the business has stopped making interest payments (because interest is added
back). But it is argued that once that happens the debtholder is unlikely to wait around (say) three years to
recover their principal while the business continues to operate in default. So does the metric measure
anything? There is also the problem of adding back taxes. This metric ignores all tax expenses even though a
good portion are cash payments, and the government gets paid first. Principal repayments are not tax-
deductible.
2. One interest coverage ratio (EBITDA /Interest Expense) is used to determine a firm's ability to pay
interest on outstanding debt. The greater the multiple of cash available for interest payments, the less risk to
the lender. The greater the year-to-year variance in EBITDA, the greater the risk. Because interest is tax-
deductible it is appropriate to back out the tax effects of the interest, but this metric ignores all taxes.

The ratios can be customized by reducing Debt by any cash on the balance sheet or by deducting maintenance
CapEx from EBITDA to form a measure closer to free cash flow.

Use by shareholders
Public investors' use of EBITDA arose from their perception that accountants' measure of profits, using accrual
accounting was manipulated, that a measure of cash earnings would be more reliable.[citation needed]

It is true that PE can use this metric. And it is true the professional analysts using detailed discounted cash flow
models should replace non-cash expenses with projected time-weighted payments. But none of that applies to retail
investors' reality.[citation needed]

EBITDA does NOT measure cash earnings because it omits all the tax expenses even though a good portion are
cash payments. It also fails to correct for other non-cash expenses, e.g. warranty expense, bad debt allowance,
inventory write-down, stock options granted.[citation needed]

It does not include the cash flows from changes in working capital. Suppose a business sells all its opening inventory
in a year and replaces the same number of units but at a higher price because of inflation. The profits of a company
using FIFO inventory valuation will not include that extra cash cost. Suppose the business is expanding and need to
stock a larger number of units. That additional cash cost is not in anyone's EBITDA measure.

When using this metric to replace accountant's earnings it presumes to measure an economic profit. But any
economic profit must include the cost of capital and the degradation of long-life assets. This metric simply ignores
both. Warren Buffett famously asked, "Does management think the tooth fairy pays for capital expenditures?"
Depreciation may not be exact but it is the most practical method available. It succeeds in equating the positions of
companies using three different ways to finance long-life assets. It can be interpreted as:[citation needed]

1. the allocation of the original cost, at a later date, when the asset was used to generate revenue. The time-
value-of-money (same argument used above) means that depreciation may understate the cost.
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2. the amount of cash required to be retained in order to finance the eventual replacement asset. Since inflation
is the basis for time-value-of-money, the amounts set aside today must be invested and grow in value in
order to pay the inflated price in the future.
3. the decrease in value of the balance sheet asset since the last reporting period. Assets wear out with use, and
will eventually have to be replaced.

Unprofitable businesses
When comparing businesses with non profits, their potential to make profit is more important than their Net Loss.
Since taxes on losses will be misleading in this context, taxes can be ignored. Capital expenditures and their related
debt result in fixed costs. These are of less importance than the variable costs that can be expected to grow with
increasing sales volume, in order to cover the fixed costs. So depreciation and interest costs are of less importance.
It is likely that an unprofitable business is burning cash (has a negative cash flow), so investors are most concerned
with "how long the cash will last before the business must get more financing" (resulting in debt or equity dilution).

EBITDA is not used as a valuation metric in these circumstances. It is a starting point on which future growth is
applied and future profitability discounted back to the present. Equity owners only benefit from net profits, after all
the expenses are paid.[citation needed]

During the dot com bubble companies promoted their stock by emphasising either EBITDA or pro forma earnings
in their financial reports, and explaining away the (often poor) "income" number. This would involve ignoring one-
time write-offs, asset impairments and other costs deemed to be non-recurring. Because EBITDA (and its
variations) are not measures generally accepted under U.S. GAAP, the U.S. Securities and Exchange Commission
requires that companies registering securities with it (and when filing its periodic reports) reconcile EBITDA to net
income in order to avoid misleading investors.

See also
Earnings Before Interest, Taxes, Depreciation, Amortization, and Restructuring or Rent Costs (EBITDAR)
Revenue
Gross profit
Earnings before interest and taxes (EBIT), or operating profit
Net profit or Net income
EV/EBITDA
P/E ratio

References
Investopedia definition of EBITDA (http://www.investopedia.com/terms/e/ebitda.asp)
Retrieved from "http://en.wikipedia.org/wiki/Earnings_before_interest,_taxes,_depreciation_and_amortization"
Categories: Generally Accepted Accounting Principles | Fundamental analysis | Private equity

This page was last modified on 12 January 2010 at 15:53.


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