Definition
EBITDA stands for Earnings Before Interest, Tax, Depreciation, and Amortisation. It is a measure of a company’s core operational profitability that strips out the effects of financing structure (interest), tax jurisdiction (tax), and non-cash accounting charges (depreciation and amortisation). The result is a figure that reflects how much cash the business’s operations are generating before these adjustments.
How to Calculate EBITDA
The formula is straightforward: start with net profit, then add back interest expense, income tax, depreciation, and amortisation. The same result can be reached by taking operating profit (EBIT) and adding back depreciation and amortisation.
EBITDA in Business Valuations
EBITDA is widely used in business valuations. Private equity firms, acquirers, and analysts commonly express the value of a business as a multiple of its EBITDA. A business generating $2 million in annual EBITDA might be valued at 5x EBITDA, or $10 million, depending on its growth rate, industry, and risk profile. This convention makes it easier to compare businesses across different capital structures and depreciation policies.
When EBITDA is a Useful Metric
One genuine use of EBITDA is comparing the operating performance of two businesses in the same industry that have different levels of debt or use different asset financing approaches. A company that leases all its equipment will have lower depreciation than one that purchased the same equipment outright, making net profit an unfair comparison point.
Criticisms of EBITDA
The criticism of EBITDA is that it adds back real costs. Depreciation reflects the real wear and eventual replacement cost of physical assets. A manufacturing business with ageing machinery will face significant capital expenditure in future years that EBITDA does not account for.
Adjusted EBITDA, which further removes one-off or unusual items such as restructuring costs, litigation settlements, or executive bonuses, is commonly presented by companies seeking acquisition or investment. Scrutinising what has been adjusted out, and why, is important before accepting EBITDA as a fair representation of recurring earnings.