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What does EBITDA tell you? EBITDA vs Adjusted EBITDA

Written by Andy

Companies seem very fond of using EBITDA to measure profitability – but what does it really measure? It doesn’t seem to include costs like employee salaries, raw materials, and production-related expenses so from my perspective it is a bit useless? Opinions?

Pre tax profit is the measure I want to see. Warren Buffett hates EBITDA, his quote ”We won’t buy into companies where someone’s talking about EBITDA. If you look at all companies, and split them into companies that use EBITDA as a metric and those that don’t, I suspect you’ll find a lot more fraud in the former group. Look at companies like Wal-Mart, GE and Microsoft — they’ll never use EBITDA in their annual report.” Says it all for me. I saw a PE presentation recently claiming that EBITDA was a proxy for cash flow and my immediate thoughts were a) if you ignore adjustments and b) what about debt interest, is that not paid from cash flow?

What does an EBITDA tell you?

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a financial metric that provides information about a company’s financial performance. EBITDA is calculated by subtracting operating expenses, excluding interest, taxes, depreciation, and amortization, from a company’s revenue.

EBITDA is often used as a measure of a company’s profitability, as it provides an indication of the amount of cash generated by a company’s operations before considering the impact of financing costs, taxes, and non-cash expenses like depreciation and amortization.

EBITDA stands for Earnings Before Interest, Tax, Depreciation and Amortisation.

It can be very useful for comparing companies in the same industry but with very different balance sheets, or with very different depreciation policies. EV/EBITDA takes into account all the capital involved in running the business, whereas you can distort the P/E with leverage.

No single ratio should be used on its own, you need to look at several, and in that context EBITDA can be useful. Ultimately cashflow related metrics are the most reliable because they are the most difficult for management to fudge, but they come with their own challenges (good luck forecasting inventories).

The cost of sales argument above is a red herring – some companies exclude certain costs from their headline revenues, but otherwise EBITDA will be after operating costs such as payroll.

Investors and analysts often use EBITDA to evaluate a company’s financial health, as it provides a useful comparison of the earnings of companies in different industries, with different capital structures or tax rates. It is important to note, however, that EBITDA does not account for important factors such as capital expenditures or changes in working capital, and therefore should not be the only metric used to evaluate a company’s financial performance.

It is often used by analysts and investors as a rough measure of a company’s cash flow and operational efficiency.  However, it is important to note that EBITDA should not be relied upon as the sole indicator of a company’s financial health, as it does not account for certain expenses like capital expenditures and working capital changes.

The easiest way to get to EBITDA is to take PBT and add back net interest charges, depreciation and amortisation. To put it in the context of the above, you would take everything from revenue down to the interest, depreciation and amortisation. Therefore, it includes COGS / Cost of Sales!

So EBITDA includes cost of sales such as employee salaries right?

Yes, EBITDA includes the cost of sales, which encomasses various direct and indirect expenses related to producing and selling a company’s good or services.  Employee salaries, particularly those involved in the production, sales, and distribution processes, are considered part of the cost of sales and are therefore factored into the EBITDA calculation.

To calculate EBITDA, you can start with a company’s net income and then add back interest, taxes, depreciation, and amortization.  alternatively, you can being with a company’s operating income (also known as operating profit or operating earnings) and add back depreciation and amortization.  In both cases, the cost of sales, including employee salaries, has already been accounted for as an expense that reduces the company’s income.

However, it is important to note that there are variations in the way EBITDA is calculated, and some companies may choose to include certain cost of sales items in their EBITDA calculation. Additionally, some analysts may choose to adjust EBITDA to reflect a company’s specific cost structure or industry norms. Therefore, it’s important to carefully examine how EBITDA is calculated and what expenses are included or excluded when using this metric to evaluate a company’s financial performance.

What is Amortization?

Amortization refers to the process of spreading the cost of an intangible asset, such as a patent, trademark, or goodwill, over its useful life. This is done by allocating the cost of the asset over a period of time, typically several years, rather than recording the entire cost as an expense in a single accounting period.

The purpose of amortization is to more accurately reflect the consumption of the asset’s value over time. As the asset is used or consumed over its useful life, the associated cost is gradually recognized as an expense on the income statement. This helps to match expenses with revenues in the appropriate accounting periods and can provide a more accurate picture of a company’s financial performance.

Amortization is similar to depreciation, which is the process of spreading the cost of a tangible asset, such as machinery or equipment, over its useful life. However, while depreciation applies to tangible assets, amortization applies to intangible assets.

So what does EBITDA really tell you!?

EBITDA provides a measure of a company’s operating profitability before taking into account the impact of financing and accounting decisions. Specifically, EBITDA tells you how much a company earns from its core operations, before accounting for interest, taxes, depreciation, and amortization.

EBITDA can be a useful financial metric for several reasons. First, it provides a simple and standardized way to compare the operating performance of companies across different industries, capital structures, and tax jurisdictions. Second, it can help investors and analysts identify companies that are generating strong operating profits, even if they are carrying high levels of debt or facing other accounting challenges. Finally, EBITDA can be useful in calculating certain financial ratios, such as the EBITDA margin, which measures the percentage of revenue that is generated from operations before interest, taxes, depreciation, and amortization are deducted.

EBITDA may not be the best measure of profitability in many cases. It does generally include costs like employees salaries (part of operating expenses), raw materials (accounted for in Cost of goods sold and therefore gross profit) and production- related expenses (probably partly accounted for in gross profit and operating expenses). It is often seen as a proxy for cash flow. It can be manipulated by some expenses (E.g. R & D costs) being capitalised and therefore taken into the DA element of the measure (depreciation & amortisation).

However, it is important to note that EBITDA has some limitations. For example, it does not account for important factors such as changes in working capital, capital expenditures, or non-operating income and expenses. Additionally, companies may use different methods to calculate EBITDA or exclude certain expenses, which can make comparisons between companies more difficult. Therefore, while EBITDA can provide useful insights into a company’s operating performance, it should not be the only metric used to evaluate a company’s financial health.

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