The term EBITDA stands for Earnings before Interest, Taxes, Depreciation and Amortization. The measurement is not an accepted metric in audited financial statements but is widely used as a substitute measurement for a company’s cash flow.
By adding back interest, EBITDA removes financing expense from a company’s profit and loss statement. However, leasing can still cause wide swings in the reporting of income for similar firms. If one company uses operating leases that are period expenses and another uses capital leases which treat the lease as a depreciable asset and interest expense, you can get very different EBITDA results.
By adding back taxes, EBITDA removes the income tax component of net income. Like interest, this removes the tax impact of choices companies have made with regard to financing and subjective tax areas. If one firm uses equity financing or is a pass through entity, such as a subchapter S corporation, while another loads up on deductible interest, the tax burden on the two firms will be quite different.
Removing depreciation and amortization is intended to balance decisions about capital expenditures and depreciation methods. Always keep in mind that most companies do need to continually invest in capital equipment. That is why many banks measure a company’s ability to repay with a fixed charge coverage ratio that incorporates capital expenditures.
EBITDA can be a useful measurement and many companies have chosen to use it as a measurement for incentive purposes. Again, common sense needs to prevail. A former employer of mine gave out significant bonuses because an enterprising Controller pointed out that by using capital leases instead of operating leases EBITDA was boosted. But the P&L and cash flow impact on the corporation was the same, the leasing choice merely shifted the cost between lines on the P&L that were excluded from EBITDA. In fact, the balance sheet now reflected additional long term assets and liabilities.
I should note that proposed changes in lease accounting are coming which will require most leases to be treated as assets and borrowing, so this type of EBITDA management will be muted.
If your bank wants to include an EBITDA measurement in your covenants, just understand how it works and build projections that allow you to predict whether the proposed covenant compliance is reasonable.
EBITDA is often the starting point for valuations in mergers and acquisitions. Adjusted EBITDA takes into account changes to the raw calculation to better show what an acquirer can expect in profitability going forward. For example, EBITDA is often adjusted for differences in a new manager’s compensation versus the previous owner’s compensation. For a good discussion of EBITDA adjustments, I recommend “The Exit Strategy Handbook” which is published by our firm. The book educates buyers and sellers and provides a framework for discussion of a business’ value. The book is available through Amazon.com.