"Demystifying EBITDA: Understanding The Key Financial Metric"
Investors want to know before they invest in a company that their money will grow over time, and they want their investment is as secure as it can be. Similarly, having a metric such as Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA) enables investors to track the financial efficiency and performance of the company they are investing in, or looking to back financially, and how their own investment is subsequently performing.
However, generally accepted accounting principles (GAAP) do not use EBITDA as a profitability measure. Some publicly trading companies use Adjusted EBITDA. This excludes additional costs such as employee stock options. They are used to reward employees with the company’s shares, which they will often retain even when they’ve left it.
A metric such as EBITDA allows investors to also compare the performance of companies, and it can be used as tool to manage risk. The EBITDA definition says it provides a snapshot of short-term operational efficiency. It tries to represent the cash profit generated by the company's operations. Essentially, it measures a company’s profitability to net income.
EBITDA permits investors and analysis to compare companies that have different investment, debt, and tax profiles. It’s often used quarterly earnings press releases. For example, Virgin Media O2 published its Q3 results to 30 September 2023 on 1st November 2023: “Development in revenue and EBITDA): Transaction Adjusted Revenue increased 7.1%, 1.3% excluding the benefit of Nexfibre construction in the current year. Growth in Transaction Adjusted EBITDA continued for another quarter at 5.6% in Q3.”
EBITDA Components
Earnings Before Interest and Tax (EBIT) - is net income before interest and taxes are deducted. It is often referred to as operating income. There is a difference between EBIT and EBITDA. Both can be used as a measure of operating profit, but EBIT excludes depreciation and amortisation. EBITDA doesn’t. The Corporate Finance Institute (CFI) says EBIT equals Net Income plus Interest, plus Taxes. It can also be calculated as EBITDA minus depreciation and amortisation.
EBITDA is often used by asset intensive industries such as oil and gas companies. They need above average levels of capital to operate. Neither of them is a GAAP metric, and some investors are wary of EBITDA. They believe it can offer an inaccurate picture of a company’s financial health. The CFI says EBITDA can be calculate in multiple ways, making it potentially complex.
Depreciation and amortisation are examples of non-cash expenses. They are reported on a company’s balance sheet, but there’s often no related cash payment during a particular financial period. With EBITDA, some non-cash expenses are often added back to operating income.
Both depreciation and amortisation calculate the value of business assets over time. Amortisation spreads an intangible asset’s costs of its lifespan, and depreciation reflects the anticipated deterioration in value of a fixed asset.
EBITDA Importance: The Significance Of EBITDA In Financial Analysis
The EBITDA calculation can highlight margins that ignore non-operating factors and their impact. These factors include interest expenses, taxes, or intangible assets, and make EBITDA’s importance is about providing an accurate picture of a firm’s operating profitability. This is why many investors and analysts use EBITDA above other metrics when they are conducting the financial and risk management analysis of companies.
Both EBIT and EBITDA add back interest and tax to net income. The focus of EBIT is on a company’s core operations, while EBITDA also considers its project earnings potential. Whether investors and analysts are looking to assess company performance, or whether a company needs to use EBITDA to get a loan from a bank, it’s vital to show financial stability and growth. Rival companies may also use it to decide upon their acquisition targets as a growth strategy.
The core strength of EBITDA is that it can be used to analyse, track, and compare the financial strength of two or more companies. It can be used to provide as a singular performance measure that can be applied across industries. Analysts can use it to consider the outcomes of operating decisions rather than focus on imposed taxes and payments. EBITDA is used in valuation ratios, to assess firms that have high-value expenses. They can detract from net profits.
The metric can also be used to estimate the available cash flow to pay debt on long-term assets. This may be equipment that has a lifespan of at least a decade. A company’s debt coverage ratio can be formulated to aid better decision-making. It is calculated by dividing EBITDA by the number of required debt payments. So, it offers insight into approximate cash generation and operations controlled for capital investments.
In the 1980s, EBITDA was often used as a proxy for measuring cash flow when leveraged buy-outs were common. During the dotcom era, it was used to evaluate often unprofitable technology companies – including telecoms firms. This was driven by a need for legitimate profitability. So, for example, there were at the time plenty of technology companies with inflated equity valuations. The Initial Public Offerings of many of these dotcom technology companies were overvalued due to increasing demand and overly positive valuation models. The CFI says high multipliers were used in these often overly optimistic and unrealistic valuations.
In summary, the key reasons why EBITDA is used are as follows:
- Performance evaluation - of operating performance and profitability. It signals how well the business is able to produce profits.
- Comparability - to compare companies in the same industry, regardless of their capital structures, debt levels, or accounting methods. This enables, for example, any interested party – such as investors and analysts – to determine how efficient a company is against its competitors.
- Cash flow analysis - EBITDA is often considered as a proxy for cash flow generation. This represents the cash flow that is generated by ongoing operations.
- Business valuations - to assess the existing and future profitability of company using EBITDA multiples and EBITDA-based valuation models more accurately. The multiples are used because of their simplicity. In their calculations, they use financial statements. EBITDA Multiples are therefore a quicker and simpler way of determining value compared to income and cost analyses. The Association of Chartered Certified Accountants (ACCA) says in its Technical Fact Sheet 167 on ‘Valuing Trading Companies’ that EBITDA Multiples can be deployed as an alternative to Price/Earnings ratio (P/E) to give an enterprise value rather than an equity value. This is to arrive at a value for equity, and it requires the deduction of net debt. It adds the EBITDA Multiples can be similarly adjusted in the same way that P/E ratios can.
- Debt analysis – an analysis of how well a company can service its debt. It can help a company to generate sufficient earnings to cover interest charges and to repay debt. EBITDA can also suggest whether there is a need for any financial restructuring.
- Ratio reference point – EBITDA acts as a reference for a number of ratios.
EBITDA: An Additional Performance Measure
EBITDA is considered to be an additional performance measure. While financial statements are prepared in line with financial reporting standards, there is increasing demand for more information. The issuers of this financial information are often willing to oblige, and to communicate their understanding of it. Whatever financial information is disclosed very much depends on the disclosure of the additional key performance indicators of the business. This includes more detailed analysis of particular individual items within the financial statements.
Graham Holt, a head of department at Manchester Metropolitan University Business School, writes in 2014 in his article, ‘Changing face of additional performance measures in UK’, which appears on ACCA’s website:
APMs [such as EBDITA] can help enhance users’ understanding of the company’s results and they can be important in assisting users in making investment decisions, as they allow them to gain a better understanding of an entity’s financial statements and evaluate the entity through the eyes of the management. They can also be an important instrument for easier comparison of entities in the same sector, market or economic area.”
EBITDA Calculation And Interpretation
Even if a company doesn’t report EBITDA, it can still be calculated from its financial statements. The formula has to consider earning (net income), tax, and interest figures. These can be found on its income statement. The depreciation and amortisation figures are either found in the notes to operating profit, or on the firm’s cash flow statement.
The two common formulas for EBITDA are:
EBITDA = Net Income + Taxes + Interest Expenses + Depreciation and amortisation (D&A).
or
EBITDA = Operating Income + (D&A)
It’s possible to calculate EBITDA margins by dividing EBITDA by total revenues to show how efficiently a firm operates. The margins measure a company’s operating profit as a percentage of its total revenue, and it allows investors and financial analysts to compare the profitability of several companies in the same industry or sector. To estimate the required cash flow for long-term debt requires the factoring out of the ITDA component. By doing so it’s possible to account for the cost of long-term assets, and for there to be an examination of profits that would otherwise be left after the cost of those tools is considered. This is how EBITDA was often utilised before the EBIDTA as a perfectly legitimate calculation.
EBITDA Example
A simple example of EBITDA is given by IG.com, involving a company with a revenue of £1 million with operating expenses of £200,000 and with £50,000 in depreciation and amortisation expenses. There is then the operating income before interest and taxes – the EBIT component of EBITDA, equating to £750,000. Subtract the interest expenses of £50,000 to get the earnings before tax figure of £700,000. Take-away taxes of £100,000 too. This means that the net income for the company is £600,000.
Let’s say company ABC’s revenue is $1 million, but it has operating expenses of £200,000 and £50,000 in depreciation and amortisation expenses. The operating income before interest and taxes (known as EBIT) is therefore £750,000. Subtract the interest expenses of £50,000. This makes the earnings before taxes figure £700,000, and if taxes are £100,000, then the net income for company ABC is £600,000. To calculate EBITDA, IG says it’s then necessary to take the operating income, and then add depreciation and amortisation back to the figure: EBITDA = £750,000 + 50,000. So, the EBITDA figure for the company is £800,000.
What Is A Good EBITDA Margin?
A good EBITDA margin is considered as being 10%. However, it’s often relative – depending on a specific industry and on a particular company’s approach to its calculation. Investopedia notes: “For example, a smaller company with a higher margin could be said to be more efficient, but a larger company with a smaller margin likely is doing more in terms of volume, and that may be the goal.”
So, let’s say that Company A has an EBITDA of £800,000 and total revenue of £8 million with an EBITDA margin of 10%. A larger firm, Company B in comparison has an EBITDA of £960,000 with total revenue of £12 million and an EBITDA margin of 12%. Naturally, this larger figure demonstrates a higher EBITDA, and yet it has a smaller EBITDA margin than Company A. So, an investor might see more potential in Company A.
Limitations And Criticisms Of Using EBITDA
As previously mentioned, EBITDA is not a GAAP measure, and it is not recognised by the International Financial Reporting Standards (IFRS). This is because the way it is calculated can vary from one company to another. There are also criticisms that it can be misused to emphasise EBITDA over net income because it’s claimed that EBITDA can make a firm look better than they really are – despite claims to the contrary in favour of EBITDA’s use.
When companies have borrowed heavily in the past, they may not have included any EBITDA figures. So, some investors consider it to be a read flag when in this situation one suddenly and prominently appears in the company’s financial statements. They may do this to hide rising capital and development costs. In this case EBITDA can be wrongly used to distract investors from the company’s shortcomings. This means that there is a temptation to use the metric to present financial decisions to a company’s advantage, such as by excluding any debt, with a view to mislead investors, financial traders, and analysts.
There are other criticisms of EBITDA too:
- EBITDA ignores asset costs - it is said that it overly presumes that profitability is a function of sales and operations alone. This makes it look as if a firm’s debt financing and assets are nothing but a gift.
- Earnings figures may be suspect - the formulas for EBITDA are simple, but companies may use different earnings figures as the basis for starting their calculations of this metric.
- Company valuations can be obscured - there may be costs excluded from the calculation of EBITDA that can make a company “much less expensive than it really is,” says Investopedia. So, an analysis of stork price multiples of EBITDA rather than an analysis of bottom-line earnings could produce lower multiples.
EBITDA certainly has its critics. The UK’s Chartered Institute of Management Accountants has a post on LinkedIn that offers ‘Top 10 reasons why EBITDA Is ‘A Great Big Lie’. CIMA claims: “Earnings before interest, taxes, depreciation, and amortisation (EBITDA) is a kind of fake story that was told to investors and credit managers about company performance and indicators of value. Know the reasons why relying on EBITDA means buying into a great big lie.”
Four of CIMA’s main concerns include the view that EBITDA doesn’t provide any consistency check for a company’s accounting practices; it ignores the cost of debt by adding taxes and interest back to earnings; it might not allow a business to get a loan because loans are calculated based on a company’s actual financial performance; copyrights and patents expire over time, while machines, tools and other assets lose their value and use; and it ignores high interest financial burdens.
This doesn’t mean that EBITDA shouldn’t be utilised at all. Instead, the advice is to examine other factors and performance indicators to that there is no intention of deceiving investors by a company with its accounting figures. AccountingWeb advises looking under the hood of any metric, using not just simple EBITDA but also EBITDA margins to learn about whether expenses are likely to eat a firm’s profitability to get an idea about the financial risk of a company. It concludes that due diligence on audited books is essential to ensure accurate accounting.
Practical Examples Illustrating EBITDA's Utility
Private equity firm Palatine Private Equity invested in holiday park firm Verdant Leisure in 2016, which operates in the North-East of England and in Scotland. The leisure company provides family-orientated self-catering lodges, caravan holidays, and holiday home ownership - located in stunning places on the coast or the hills of northern Britain.
The primary goal of the investment was to help Verdant Leisure, which was established in 2010, to consolidate the UK holiday park market by supporting a growth strategy with its experienced, customer-focused team.
The equity firm explains: “In April 2016, we invested £14.5m in Verdant in return for a 72% equity stake in the business. Verdant had four parks with more than 2,100 pitches. The deal, valued at £40.5m, saw Palatine Partner Ed Fazakerley and Investment Manager James Painter join the board as non-executive directors.”
“Our growth strategy was to scale the group by supporting management’s buy and build strategy, expanding and upgrading its existing parks, and growing holiday hire revenues. The management team had previously completed a private equity deal and proven they could successfully acquire and integrate holiday parks into the group.”
Together they achieved growth by acquiring other holiday parks in the UK – many of which were owned by families and individuals. Verdant Leisure also upgraded its existing parks and grew its holiday hire revenues. Verdant Leisure’s management team provided they could successfully acquire and integrate holiday parks into their group. They had also previously completed a private equity deal to help fund their growth strategy.
The ambition was to also add value to the company. After mapping the market for further acquisitions, Verdant acquired 5 additional parks across Scotland and Northern England. Palatine part-funded these acquisitions. Pitch number subsequently grew from 2,100 to 3,200. As a result, Verdant became the fifth largest holiday park operator in the UK. Palatine says sales also from £15.5m in FY16 to £32.6m in FY20.
Verdant Leisure also opened a new headquarters in Lancaster to bring senior management under one roof. The company also boosted its team with new recruits and set up a contact centre. This led to a doubling of holiday let revenues. The firm also introduced people development and employee engagement programmes, as well as an Environmental, Social, and Governance (ESG) that led the company to win the Green Tourism Award.
Palatine says the overall strategy was very successful: “The results – We exited the business in 2021 in a sale to Pears Partnership Capital with a returns multiple of 3.7x. During our investment EBITDA grew from circa £4m to £8.5m, with turnover rising to £32.6m as of 2020.”
In this case EBITDA was used to demonstrate the success of Verdant Leisure’s growth strategy and to show that buying Palatine’s equity share was likely to be profitable for Pears Partnership Capital – making it a viable deal. A good EBITDA is one element that can attract investors. It will also put Verdant Leisure in good stead if it decides to merge with another firm or is acquired in the future.
Deliveroo – Segment Analysis
Deliveroo’s Annual Report for 2022 explains that EBITDA was used to assess the performance of certain operating segments within the market, and to enable the company to better allocate resources. The segment performance looks at a geographical split between the UK and Ireland and International (overseas jurisdictions other than the UK and Ireland). the Group’s Chief Executive Officer (the Chief Operating Decision Maker (‘CODM’) used segment adjusted EBITDA. Both EBITDA and Adjusted EBITDA dropped between 2021 and 2022 from £248.1 to £184.2 respectively - probably due to a relaxation of Covid lockdown measures and market changes.
The company nevertheless says it reached adjusted EBITDA profitability in H2 2022. It claims it made “excellent progress on our path to profitability, reaching adjusted EBITDA profitability in the second half of 2022.” It also suggested that it aimed to achieve “adjusted EBITDA breakeven at some point during H2 2023 to H1 2024.” It achieved an Adjusted EBITDA margin in the second half of 2022 of 0.2% as a percentage of Gross Transaction Value (GTV). It also highlights that it uses Adjusted EBITDA to supplement its performance assessment as an APM. It will have used these figures to direct its growth strategy, and to communicate it with its investors.
