Behind the EBIT(DA)

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Some call it the funhouse Hall of Mirrors in the world of financial reporting. Charlie Munger from Berkshire Hathaway goes even further by calling it the BS earnings. Technically EBITDA is an abbreviation that stands for earnings before interest, taxation, depreciation and amortisation. The beginnings of its widespread application date back to 1980s and to the wave of leveraged buyouts in the US when EBITDA offered a quick way to estimate a companys ability to take on and service debt.

There are some good reasons explaining the popularity of EBITDA as a concept:

  • EBITDA is a fairly simple and straightforward measure that does not require too much research or complicated calculations to arrive at. An article published by Financial Times attributes the almost universal acceptance of EBITDA as a metric to its sheer elegance it comes straight off the income statement, is capital structure agnostic and takes out recurring non-cash charges.
  • EBITDA is a very useful metric when one needs to compare companies across industries, sectors and geographies. By excluding the potentially distorting effects caused by different taxation rules and interest charges EBITDA allows to get a fairly accurate comparison.
  • The concept itself is easy to understand and dropping the nice-sounding abbreviation occasionally helps the speaker to demonstrate some financial sophistication.

EBITDA as a term is not defined by any of the accounting standards and there are no uniform rules of calculating it (the concept of adjusted EBITDA and the various creative attempts of adding other charges, like rent or management fees, to it may warrant a separate note or two). Over time EBITDA has gradually become a proxy for cash flow and both terms are actually being used interchangeably. Regretfully, such liberal treatment is not safe and might backfire. For instance:

  • EBITDA as a metric disregards the changes in working capital. The company earnings reflect the difference between the companys revenues and expenses, but not the amount of cash collected during the period. As a consequence, EBITDA might overstate the cash flow in periods of working capital growth.
  • EBITDA implicitly assumes that the non-cash depreciation and amortisation charges are part of free cash flow and are available for debt service. This approach does not recognise the need for at least a certain minimum level of reinvestment, or maintenance CAPEX, required for a business to sustain its operations. And the needs for new investment to grow the business are being ignored completely.
  • Although widely used as a rule of thumb in M&A context, EBITDA multiples fail to convey important information about the target company, for example, the quality of EBITDA itself. It could be assessed by breaking it down to its components, or by separating EBIT from depreciation and amortisation. EBIT, which represents the operating income, is a measure of how much profit or loss the business generates. The higher the proportion of EBIT in EBITDA, the higher is the quality of the latter and the more reliable an indicator it is.

For those interested to learn more, there is a very comprehensive analysis prepared by Moodys Investors Service which is available here.

EBITDA has become an integral part of financial lingo and there is nothing wrong with the concept as such. Provided, though, that we recognise its limitations and do not base all our trust and reliance on it alone!

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