The value of an enterprise is hard to define given all the varying metrics that need to be part of the calculations. An entrepreneur might wonder what is EBITDA and how does it impact business practices. This calculation method is used by different professionals when looking to find out the financial standing of a company.
Over the years, business owners and accountants have developed different methods of measuring the worth of companies and EBITDA is one of them. Here, entrepreneurs, investors, and managers can learn more about what is EBITDA, its core concepts and pros and cons.
The Concept of EBITDA
EBITDA is a short-form for Earnings Before Interest, Tax, Depreciation, and Amortization, which is a metric for understanding the financial health of an enterprise without factoring in tax conditions and accounting decisions. When looking at the question of what is EBITDA, its origin and application in everyday business are some of the elements to consider.
The generally accepted accounting principles provided a standard method of calculating profit, which is gross revenue minus expenses. However, in the 1980s, the concept of EBITDA came into being. Companies that focused on leveraged buyouts to assess the profitability of distressed businesses popularized this calculation technique. The aim was to gauge if it was possible for investors to pay off debts after buying out a company.
The concept here is to remove all expenses that are not part of the core functions of a company. The noise from both operating and non-operating effects can make it difficult to come up with a concrete measurement. EBITDA simplifies the process by concentrating only on the operating effects.
A manager or entrepreneur may wonder what is EBITDA’s role in the management of an enterprise. It is useful when comparing the performance of two entities with similar operations but different tax brackets. The point is to improve the accuracy of comparisons between two organizations.
EBITDA is suitable for specific companies and without the right application, it can generate false results. Experts recommend using other metrics such as EBITDA margins, which indicate the portion of a company’s profits that go towards operating expenses. Note that the effectiveness of EBITDA as a measure of financial health will vary from one enterprise to the next.
Bonus read – What Are Earnings Per Share?
Advantages and Disadvantages of EBITDA
Understanding where your business stands financially allows you to make informed decisions regarding its development. EBITDA is a comprehensive formula that makes it possible to not only measure financial health but also generate useful comparisons as Business News Daily puts it. Other features to consider when answering the question of what is EBITDA are the pros and cons of this calculation strategy. As with other value-measuring methods, EBITDA doesn’t cater to all requirements. Investors and business owners must first grasp the upsides of using this method and the potential downfalls. This information allows you to make the necessary adjustments to avoid deceptive results that may impact the growth of your enterprise negatively.
Advantages of EBITDA
The EBITDA formula makes it less complicated for investors to learn about the profitability of a company, which is not always easy to achieve. When looking to sell or buy an enterprise, calculating its ability to make money is part of your due diligence. Before you can join a company as an investor, you must know if the current business model is working and the financial health is one way to assess that. This method of calculation ensures that entrepreneurs don’t jump into the wrong ship when seeking investment opportunities or making acquisitions.
2. No Subjective Metrics
When trying to understand the advantage of EBITDA, the elimination of non-operating costs is one aspect to look at. Calculating amortization and depreciation reveal subjective elements to them, which can influence the measure of performance. These expenses are unlike the rest because they are not cash.
The two apply to assets that the enterprise has already paid for. Because the costs depend on the value of the underlying assets over a given period, they are calculated based on projections and experience, which can be subjective. By removing these expenses when making calculations, EBITDA offers a more accurate measure of how well a company is doing by only focusing on the daily expenses required for the operations of a business.
3. Making Comparisons
The efficiency of an organization is another critical factor when strategizing the way forward. Comparing an enterprise against its competitors is one way of gauging the effectiveness of its business model. With EBITDA, business owners and investors can easily put one company against another in the same industry. Interests, taxes, depreciation, and amortization vary from one entity to the next. So, removing them from the equation makes comparisons easier.
Disadvantages of EBITDA
1. Can Be Inaccurate
One principal argument against EBIDTA as a measure of profitability is that the formula can fail to provide the right information. Interest and taxes are two major aspects that influence the profits of a company. Depreciation and amortization can also eat away at the profit margins, especially in young companies. Because EBITDA does not include them, it means the method is not a full representation of actual earnings. Ignoring the impact of some of these expenses can have a negative impact on the financial health of a company.
2. Subject to Misuse
Another downside to consider when dissecting what is EBITDA is the manipulation of the formula to make an enterprise appear more profitable than it actually is. When you calculate the performance of a business venture without the interests, taxes, depreciation, and amortization, it tends to overstate the cash flow available. A company that may be in distress may present a favorable financial performance to investors to source funding. EBITDA can give a misleading figure of the money available to pay off debts.
3. Doesn’t Adhere to International Standards
EBITDA is not part of GAAP, so companies are not obligated to include it in their financial statements. It also deviates from the standard measure of cash flow. This is due to the fact that the formula doesn’t factor in the evolving nature of the working capital. The day-to-day operations assets and liabilities are wildly dynamic and necessitate some adjustments to the cash flow every time they shift. EBITDA does not include these costs. This means it ignores the changes that every enterprise is bound to experience in its practices.
The financial health of a company is necessary for many reasons and EBITDA is one technique that gets you the relevant information. With EBITDA you calculate the profit generation capabilities of a company without looking at the non-core expenses like interests and non-cash costs such as depreciation and amortization. Entrepreneurs should learn what is EBITDA and its effects when evaluating the profitability of a company. For solid figures, businesses should ensure that they use verified and audited financial statements when measuring performance.