Getting to grips with ebitda
What is ebitda? What can it be used for? And under which circumstances should this number be viewed with caution?
thefinancial industry is one characterised by massive amounts of jargon and one of these terms is ebitda. It gets used in isolation but also in ratios such as debtto-ebitda and ebitda margin. But what is ebitda?
What exactly is it?
To break down the acronym, it is earnings before interest, tax, depreciation and amortisation. The earnings figure indicates just that – income less direct costs and usually called net income. Interest is interest being paid on debt, in a few very rare cases it may be interest received but for pretty much all listed companies net interest is a payment as debt is larger than cash holdings. Tax is tax being paid to Sars or tax authorities in any other country they operate in. Depreciation is the write-down of tangible assets such as equipment, while amortisation is the write-down of intangible assets such as goodwill.
Ebitda is supposed to be a good, clear snapshot of the things that a company controls at the operational level. In a sense, it indicates real profit before all the nasties of tax, debt payments and write-downs.
What to use it for
I do like it for that purpose, although there are some very large drawbacks that I will discuss shortly. Where it can be useful is when one compares two very similar companies at their operational levels and then looks at the various ratios. This gives a clear way to see how the two stack up against each other. It also helps us get an understanding of the differences between industries. For example, by looking at average ebitda ratios in healthcare versus retail, we can check if there are trends that indicate that the one industry is more profitable than the other on average.
It also works very well for comparing small companies against much larger companies when used as a ratio.
In truth, this is the case with most ratios and why we usually turn to ratios rather than absolute numbers.
But be careful…
The risks associated with using ebitda to judge a company’s performance are interest and writedowns. A company loaded with debt could have great ebitda growth and margins but the debt pile and the cost of that debt could be killing it, so I always want to also look at the ebitda-to-debt ratio as well as having a thorough look at the overall debt situation. Write-downs are another issue. Be they tangible or intangible, write-downs are often merely glanced over, but they are assets that have been paid for and so writing them down means the company is out of pocket and the asset side of the balance sheet is worse off because of the write-down. Tangible equipment has a finite life span, for example a truck used in the business does not last forever. As a result, accounting standards allow for these assets to be written down to zero value after a defined period when they no longer have value and likely no longer have any use. Another issue is that a positive ebitda figure does not mean a company generates cash and in fact this term arrived during the dot-com era when positive cash flow was a dream for the hot stocks of the day. The reality is that equipment needs to be replaced, working capital may need to be increased and none of this is seen within ebitda. Warren Buffett asked: “Does management think the tooth fairy pays for capital expenditures?” and it’s a fair question. Further, since ebitda is not an official regulated accounting term as defined by International Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP), we’re not always comparing like with like. To sum up, while ebitda can be useful, I generally view it with a sceptical eye and prefer established IFRS numbers.
Where it can be useful is when one compares two very similar companies at their operational levels and then looks at the various ratios.