During the dot-com boom, EBITDA became a popular way to measure how healthy a business was. EBITDA scores became the talk of Silicon Valley cocktail parties, where party goers would ask each other, “How soon will you be EBITDA positive?”
Today EBITDA remains a valuable, if controversial, number for evaluating a company’s earnings. After all, the WorldCom meltdown was facilitated by financial fraud related to EBITDA.
Before we examine why EBITDA is favored by some and scorned by others, we need to consider EBIT (Earnings Before Interest and Taxes). As you might know, EBIT is synonymous with Operating Income, and is the profit or loss that is generated by operations of a business before interest expenses and taxes. In essence, it’s the number that tells you how much profit or loss your operation is generating.
EBITDA is a form of EBIT. Actually, Joe likes to say it’s an obvious form of EBIT — EBIT “DUH” (sorry…it’s hard to make jokes about EBITDA). It stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.
Depreciation and amortization are unique expenses. First, they are non-cash expenses — they are expenses related to assets that have already been purchased, so no cash is changing hands. Second, they are expenses that are subject to judgment or estimates — the charges are based on how long the underlying assets are projected to last, and are adjusted based on experience, projections, or, as some would argue, fraud.
EBITDA is a number often used in the financial industry as a loan covenant. Borrowing limits for businesses often are set as percentages of EBITDA. One of the most common methods to value small businesses being acquired is by using multiples of EBITDA. For example if you own a business that generated $1 million dollars of EBITDA last year and companies in your industry typically sell for 7 times EBITDA, then the sale price of your business will probably be in the $7 million dollar range.
Bankers like EBITDA because it will eventually represent operating cash flow (since the non-cash expenses are added back in). That helps to explains why bankers like the ratio in loan covenants. If EBITDA is good, the thinking is, operating cash flow will not be far behind.
EBITDA can also be misused. In the mid-nineties when Waste Management was struggling with earnings, they changed their depreciation schedule on their thousands of garbage trucks from 5 years to 8 years. This made profit jump in the current period because less depreciation was charged in the current period. Another example is the airline industry, where depreciation schedules were extended on the 737 to make profits appear better. When WorldCom started trending toward negative EBITDA, they began to change regular period expenses to assets so they could depreciate them. This removed the expense and increased depreciation, which inflated their EBITDA. This kept the bankers happy and protected WorldCom’s stock.
Because EBITDA can be manipulated like this, some analysts argue that a it doesn’t truly reflect what is happening in companies. Most now realize that EBITDA must be compared to cash flow to insure that EBITDA does actually convert to cash as expected.
In our Financial Intelligence Test one of the questions people miss most often involves EBITDA (even senior finance people missed the EBITDA-based question). Many of us can define what the term EBITDA means, but we also should know why it’s important and how it is should be used.
Does your company measure EBITDA? How helpful have you found it to be?
Originally published on Harvard Business Review Blog.