This article was originally published on CoreEarnings.com .
What is EBITDA?
EBITDA (Earnings before Interest, Tax, Depreciation and Amortization) is a commonly used earnings metric in financial analysis. The central motivation for using EBITDA is that shows a firm’s earnings from its core business activities and it is more of a cash based metric.
The first thing to note about EBITDA is that it is a ‘pro-forma’ measure in that it is not an earnings measure sanctioned under generally accepted accounting principles (GAAP). Therefore EBITDA does not appear on an Income Statement and is instead calculated by the firm (or analysts) and reported separately.
The US accounting standards board (FASB) has a strict definition for calculating EBITDA which is adding back only tax, interest, depreciation and amortization to Net Income as reported on the Income Statement. However, most firms choose to report ‘Adjusted EBITDA’ or ‘Sustainable Earnings’ in their earnings releases. These measures and non-standard and vary from firm to firm making comparisons difficult. Typically, in addition to the standard EBITDA adjustments, these measures will also add back items deemed as ‘non-recurring’ such as asset writedowns.
Myth : EBITDA is Cash Earnings
EBITDA is often used interchangeably with cash flow , however it is definitely not a purely cash measure. Whilst some non-cash items such as depreciation are excluded, the earnings element in EBITDA is still based on the accruals concept and so revenue can be recognised even when the cash has not yet been received. If cash earnings are required for analysis, there is already an item in the standard GAAP accounts – Cash Flow From Operating Activities that is the cash amount earned from a firm’s core business. EBITDA is thus a strange hybrid of an accruals based and a cash-based earnings measure.
It is also difficult to find a convincing rationale for excluding many ‘non-cash’ items such as depreciation. The motivation for removing depreciation and amortization is that they are non-cash expenses. However this is very misleading, the asset which is being depreciated was originally purchased with cash and excluded as an expense on the basis that the asset can be used over several years and so only a proportion of the cost should be included as an expense each year. In the same way, asset impairments and writedowns are based on previous cash payments.
Myth : EBITDA is Sustainable
A common argument for using measures such as EBITDA is that they exclude one-off charges such as asset writedowns which do not recur. This logic has some merit if a company seldom has such charges but the reality is that ‘one-off’ charges are often frequent occcurances for some companies (such as Hewlett Packard) and are indicative of a core issue with the business (such as the inability to generate organic growth and a poor acquisition policy in the case of HP). Therefore excluding these charges would give a misleading impression of the company.
Why the Popularity of EBITDA?
The main proponents of EBITDA and especially its derivatives such as Adjusted EBITDA are the reporting companies themselves. Using EBITDA measures allows firms to ignore a wide variety of costs and expenses and so flatter the business.