Operating Cash Flow Formula
Meaning of EBITDA
EBITDA refers to earnings of the business before deducting interest expense, tax expense, depreciation & amortization expenses that is used to see the actual business earnings and performance-based only from the core operations of the business and is also used to compare the performance of the business with that of its competitors.
From the below graph, we note that Google EBITDA has increased by 274% from $8.13 billion in 2008 to $30.42 in 2016.
Top 2 Methods to Find EBITDA
Let’s discuss the following methods.
EBITDA = Operating Profit + Depreciation Expense + Amortization Expense
Here, it would be useful to get an idea of the financial terms we are using, to be able to understand Earnings Before Interest Taxes Depreciation and Amortization and its calculation better.
It essentially refers to the profit earned from the company’s core operations. Also known as EBIT (Earnings Before Interest and Taxes) which gives a fair idea of a company’s ability to generate profits while removing any earnings other than those from the core operations. For instance, a company might be earning from its investments and from the sale of assets as well but these types of earnings are excluded from the operating profit.
Let’s see how we can calculate this:
Operating Profit or EBIT (Earnings Before Interest & Taxes) = Revenue – Expenses
- Let us suppose that a company reported sales revenue of $30,000,000 for a certain fiscal year and the operating expenses amounted to $12,000,000.
- Here, the company’s Operating Profit or EBIT = $30,000,000 – $12,000,000 = 18,000,000
These expenses would include depreciation, amortization, salaries & utilities, cost of goods sold along with general and administrative expenses.
Depreciation is basically the cost of a company’s assets allocated over its duration of useful life. This includes tangible assets like buildings, machines, and equipment, etc., a portion of whose cost is allocated as depreciation expense in the financial statements for each fiscal year.
Let’s see how depreciation is calculated:
Suppose a company purchased some assets with a working lifetime of 10 years, Now, if these tangible assets (machinery, equipment, etc) cost $6,000,000, then we can calculate yearly depreciation expense by dividing the total cost with the total number of years it might last. In this case, it would be $6,000,000/10 = $600,000 annual depreciation expense
It only differs from depreciation in that it is the allocation of a company’s intangible assets over the duration of its useful life. These intangible assets could include intellectual rights and other such things that may not be covered in the conventional assets of a firm. Suppose if these intangible assets cost $2,250,000 which would last a total of 5 years, then we can calculate amortization like this: $2,250,000 / 5 = $450,000
To calculate EBITDA, it would be important to note that earnings, interest, and taxes of a firm are reported on the income statement whereas depreciation and amortization figures can be found in the cash flow statement or in the profit and loss report.
We have already calculated the EBIT in our example above. Taking it one step further,
Now let us assume that the operating profit of a firm is $18,000,000, depreciation costs of $600,000 and amortization expense of $450,000.
EBITDA = $18,000,000 + $600,000 + $450,000 = 19,050,000
A great deal depends on how companies interpret these metrics and how they define things like operational profit and operational income. In some cases, a company might interpret this metric in such a manner as to include all expenses and income generated, including those from core operations as well as from other sources. When calculating EBITDA based on this approach, one would need to start with net income and add back interest, taxes, depreciation, and amortization. As already explained, this would include income from secondary sources as well including the sale of assets or from investments.
EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortization
Suppose, if a company has a net profit of $20,000,000 and taxes worth $3,000,000 and interest payments of $1,000,000, with depreciation and amortization as given earlier.
With is approach, EBITDA would be $20,000,000 + $3,000,000 + $1,000,000 + $600,000 + $450,000 = $25,050,000
Now, these two methods have yielded completely different figures for EBITDA, which can be misleading unless the gap is explained with the help of some investment profits and or proceeds from the sale of assets that one of the methods may not have taken into account. This takes us to the next logical question.
Below is the Income Statement snapshot of Starbucks Corp. We note that Earnings Before Interest Taxes Depreciation and Amortization is not directly provided in the income statement.
- EBITDA = EBIT + Depreciation and Amortization.
- EBITDA (2017) = EBIT (2017) + Depreciation and Amortization (2017)
- = $4,134.7 + $1,011.4 = $5,146.1 million
Likewise, you can calculate the EBITDA for 2016 and 2015 as well.
EBITDA is a non-GAAP Measure
Most of the experts agree that EBITDA is not a part of standardized performance metrics which are calculated using certain specific norms. One of the leading criticisms of Earnings Before Interest Taxes Depreciation and Amortization stems from the fact that it is a non-GAAP measure of a company’s operational performance. GAAP stands for Generally Accepted Accounting Principles, representing a common set of standards adhered to while carrying out any kind of accounting-related calculations.
In general, non-GAAP measures and calculations are not considered on par with GAAP-compliant measures for the reason that in the latter case, companies have a higher level of discretion than is desired in any accounting calculations. This makes it possible for a firm to manipulate the figures in non-GAAP measures to suit its own interests. This is also the case with EBITDA, which can be manipulated to artificially ‘inflate’ corporate earnings and hence a major reason for its widespread criticism.
However, if one considers these drawbacks in mind while calculating and considering Earnings Before Interest Taxes Depreciation and Amortization as a measure of a company’s operating profits, then it would be possible to make use of this as only one of the several calculations available for the purpose. To help understand this metric better, we would start with its basic calculation and study its underlying components before moving on to specific EBITDA-related figures employed by analysts along with an analysis of their credibility or lack thereof.
EBITDA Manipulation & Interpretation
Can EBITDA be manipulated to show inflated earnings? As we have already hinted above, different methods of calculating EBITDA have created a lack of clarity among investors about the reliability and credibility of this metric. It is evident from the above illustrations that simply by defining operational profit and income differently and including or excluding income from non-core operations, it would be possible to arrive at drastically varying figures.
- The inherent problem with Earnings Before Interest Taxes Depreciation and Amortization is that a company is free to utilize one of the methods to calculate the figure in one year and follow another one next year in keeping with whatever figures show the firm in a better light. For instance, if a company does not have enough income from core operations but is earning a good sum from other investments and or sale of assets, then it might choose to show inflated earnings by employing a method for calculation of EBITDA where these additional sources of income are also included. Another aspect is related to Depreciation and Amortization, which are non-cash expenses but their figures are also liable to manipulation by a firm with the intent to inflate its EBITDA.
- The fundamental issue which makes such manipulations possible is that EBITDA is a non-GAAP metric as we have already discussed at the beginning of this article. Often, it is also mistaken as a reliable measure of the cash flow of a firm whereas it is intended more as a measure of profitability, that too when taken into account with reliable data on changes in working capital and other figures. It was originally brought into popular use with companies with a sizable amount of debt as an indicator of its ability to service debt.
Slowly, this measure gained popularity with companies having expensive assets written down over long periods of time. By using Earnings Before Interest Taxes Depreciation and Amortization, they could present a truer picture of its earnings by adding back depreciation and amortization. However, later this measure came to be widely used by a number of companies whose profitability could not be accurately portrayed through this metric, especially tech companies, which had no such expensive assets to be written down over a relatively long period of time.
Based on the above analysis, we can easily understand that EBITDA may not be the most reliable metric for measuring operating profitability, especially if used in isolation. However, if used with a little care, it could well be used to evaluate corporate profit (when used along with other reliable data and figures) and allows for different firms to be compared for their debt-repayment capabilities as well.
The ability to service debt is an important component for the survival and growth of any business and Net Debt to EBITDA Ratio can be pretty useful in measuring this ability. Having said that, one must keep in mind the shortcomings of Earnings Before Interest Taxes Depreciation and Amortization while making use of it, one of the primary issues being that it is not an accurate indicator of operating cash flow of any company. This is because it does not take into account the changes in the working capital of the company, which is a key determinant in the context of operating cash flow for a firm.
Another concern, as we have already discussed at the beginning of this article, is about EBITDA being a non-GAAP metric which makes it susceptible to manipulation by companies in a bid to show higher profitability than there is. If these limitations are kept in mind, there is no reason why Earnings Before Interest Taxes Depreciation and Amortization cannot be used by analysts as an additional tool for evaluating and comparing the profitability of a firm along with studying and comparing their ability to service debt.
This has been a guide to EBITDA (Earnings Before Interest Taxes Depreciation and Amortization), Top 2 formulas used to calculate EBITDA along with examples. You may also have a look at the following articles to learn more about Financial Analysis –