EBITDA
What is EBITDA?
EBITDA is an accounting method to calculate a company’s net profits (or earnings). It is an acronym for:
- earnings before interest
- taxes
- depreciation
- amortisation
How to calculate EBITDA
As the name suggests, EBITDA is calculated by adding four items back to net profits (or earnings). It’s used as a measure of the cash a business generates - cash that can be invested in the business, used to pay debts or returned to shareholders.
EBITDA formula
Below is the formula for calculating EBITDA:
EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortisation
or
EBITDA = Operating Profit + Depreciation + Amortisation
Depreciation and Amortisation
Depreciation and Amortisation represent the wear and tear on a company’s assets.
An example might help. Imagine you open a printing business and spend £10,000 on your printing press. Each year, after paying for ink, staff costs and taxes etc., you have £1,000 left over. After 10 years the printing press breaks and becomes worthless scrap.
Did you make a profit?
No, because you spent £10,000 on the press at the start, and then earned £1,000 a year for 10 years. You ended up with exactly what you started with: £10,000.
Accountants deal with this issue by spreading the cost of the printing press over its useful life. This shows up as Depreciation in company accounts each year but, crucially, all the cash was spent in previous years. Depreciation is therefore described as a non-cash charge.
While Depreciation relates to physical assets like printing presses, Amortisation relates to intangible assets like brand names or patents. It works in exactly the same way – with upfront cash costs spread across an asset's working life.
We add depreciation and amortisation back in EBITDA because we want to see how much cash is available to management to invest going forward.
Interest and Tax
Unlike Depreciation and Amortisation, the Interest payments companies make on their debt are real, cash costs. We add them back because, in theory, management can choose how much debt the company should hold.
Companies pay Taxes on profits – and remember we’re interested in cash here, not necessarily profits. Moreover interest payments are tax deductible. Since management can decide how much debt a company holds, they can also influence how much Tax the company pays.
To simplify things we just add both Interest and Tax back for EBITDA – remember we said it was rough and ready.
What does EBITDA mean for investors?
EBITDA is a quick, if imprecise, measure of the cash that’s available to management each year. It’s commonly used when thinking about how well a company can service its debts – because debt holders will always demand what they are owed before taxes or reinvestment.
On the other hand, it doesn’t include some pretty important running costs, and if all your cash is tied up servicing debt that’s not good news for shareholders.
Investors should be careful with EBITDA and similar alphabet accounting metrics, particularly for capital intensive businesses with large depreciation costs or interest payments. In our view EBITDA works best as a rough measure of cash flow for relatively capital light businesses.
Remember to keep in mind key figures shouldn’t be looked at on their own – it’s important to understand the big picture.
Related topics
Read more related glossary terms
Base interest rate
A base rate is the interest rate central banks, like the Bank of England (BoE) in the UK, will charge commercial banks and building societies for loans. The base rate is also known as the bank rate or the base interest rate.
Yields
A yield measures any income from an investment over a set period of time, such as dividends from shares or interest from bonds.