What does EBITDA stand for?
EBITDA stands for ‘Earnings Before Interest, Taxes, Depreciation and Amortisation’. It is a measure of profitability. The benefit of EBITDA is that it focuses on a company’s core performance rather than the effects of non-core financial expenses.
The main drawback of EBITDA is that financial expenses can make a great difference to a company’s financial health, thus creating a misleading impression.
Example of EBITDA
There are two ways to perform the EBITDA calculation. The first EBITDA formula is:
Net Income + Taxes + Interest Expenses + Depreciation + Amortisation = EBITDA.
The second is:
Operating Income + Depreciation & Amortisation = EBITDA.
All of these variables can be found on a company’s profit and loss statement or its balance sheet. Most are shown as individual line items. Operating income may not be shown but can easily be calculated: simply subtract the operating expenses from the gross income.
The EBITDA margin measures a company’s operating income as a percentage of its overall revenue. The formula for calculating it is:
EBITDA/total revenue = EBITDA margin
Overall the EBITDA margin has much the same advantages and disadvantages as EBITDA itself. The key difference is that it is expressed as a percentage. This makes it usable in like-for-like comparisons, for example, between a company and its competitors in the same industry.
EBITDA vs EBITDAX
EBITDAX stands for ‘Earnings Before Interest, Taxes, Depreciation (or Depletion), Amortisation, and Exploration Expense’. It is used only in connection with exploration and production companies. These are companies that aim to extract and sell natural resources such as oil and minerals.
Using EBITDAX essentially has the same effect as using EBITDA. It should, however, be noted that the EBITDAX calculation will be influenced by the methods used to calculate the exploration costs.
The successful-efforts method, as its name suggests, only allocates the expenses of successful explorations to EBITDAX. The full-cost method allocates all exploration-related expenses to EBITDAX.
To use EBITDAX to calculate the EBITDAX margin, be absolutely sure that you’re comparing like with like. If one company uses the successful-efforts method and the other company uses the full-costs method, your comparison could be highly misleading.
Benefits of EBITDA
EBITDA indicates how well the company is managing its day-to-day operations, including its core expenses such as the cost of goods sold. As such, it is a very fair indicator of a business’s current state and potential. In some cases, it is much fairer than either gross profit or net income.
Gross profit shows a business’s turnover but not how much of that money is being retained after expenses. Net income does this, but it can be heavily influenced by factors beyond a business’s direct control.
For example, if governments or local authorities are struggling to balance their own books, they may resort to raising taxes. There is nothing any company can do about this, but their net income is still reduced.
Downsides of EBITDA
The very nature of EBITDA means that it only looks at part of a business’s financial story. This part is undoubtedly important but so are the parts ignored by EBITDA. In particular, companies which pay high interest on their debts could find themselves dangerously exposed to changing circumstances.
For example, if its debts are at variable interest rates (also known as tracker rates), they will increase if the Bank of England raises the base rate, also known as the inter-bank rate. Any rate increases might hit their customers too, which could result in their own cash-flow issues.
EBITDA is a perfectly valid measure and is useful to investors. For example, it is the basis for the EBITDA margin used to benchmark a company against its peers. EBITDA should always be assessed together with other key performance indicators such as operating income and net income.
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