EBITDA is a financial term used a lot in business, but what does it mean and what does it measure?
While it is often used interchangeably with other measures of Net Profit or Operating Profit, there are key differences in what EBITDA excludes and why it is used. EBITDA, Earnings Before Interest, Tax, Depreciation & Amortisation, is a profit measure largely used by business investors and Private Equity as a way of comparing different businesses across different sectors, industries, or business models when valuing a business.
By excluding interest, taxes, and depreciation & amortisation from the calculation it provides a more accurate earnings figure when calculating the Enterprise Value or Gross Business Value.
However, when evaluating a businesses operational performance, it is prudent to include depreciation & amortisation in the calculation, which is known as EBIT. While depreciation is not a cash expense, per se, it should be included in the calculation of earnings, so that you are accounting for the capital equipment required in the running of the business.
Excluding interest and tax provides a better indicator of operating performance, as they are directly tied to how the business is structured, in both the debt-to-equity structuring and entity structuring.
However, when evaluating a business from an owner’s perspective, it is wise to measure the business on Net Profit before Tax, as this is an accurate reflection of the return in the hands of the owner. How an owner decides to structure a businesses debt-to-equity has a direct impact on the businesses return, year on year.
While all three terms are similar in what they reflect, it is important that you understand how they are measured in the business and how your business model or type impacts these measures.
Example 1:
Two ‘buy-sell’ businesses are operating in the healthcare industry and both have the same EBIT. However, Business 1 trades with a low debt-to-equity ratio compared to Business 2 which trades with a high debt leverage. While their EBIT is identical, the Net Profit before Tax would be different due to Business 2 having a higher interest cost to fund the business model.
However, in this case, Business 2 would likely have a greater return on the invested capital (ROIC), as would be returning a slightly lower Net Profit, with a substantially lower capital investment.
Example 2:
Two businesses are operating in the automotive market, selling to the same product to the same customers. Business 1 is a buy-sell business; however, Business 2 is a manufacturer. Where these businesses have the same EBITDA, their Net Profit would be significantly different due to the higher CAPEX requirements of a manufacturer.
As with all financial ratios, there is no one measure that can be used to measure the performance of a business, and a broad understanding of how all the different ratios apply to your individual circumstance and business is required.