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Earnings before interest, taxes, depreciation, and amortization (EBITDA) is a ratio that indicates how much money is made and accessible to pay down debt before those costs are paid. Debt/EBITDA gauges a business's capacity to settle its accumulated debt. A high ratio result can suggest that a business has an excessive amount of debt. In the covenants for business loans, banks frequently set a specific debt/EBITDA target that a firm must maintain in order to avoid having the full loan fall due immediately. Credit rating agencies frequently use this statistic to determine a company's likelihood of defaulting on issued debt, and businesses with a high debt/EBITDA ratio may not be able to properly pay their debt, which could result in a decreased credit rating. 

EBITDA Unveiled: Beyond Net Income
EBITDA (Earnings Before Interest Taxes Depreciation and Amortization), emerges as a captivating alternative to net income, offering a distinct perspective on a company's profit landscape. By encompassing depreciation and amortization, along with taxes and debt-related costs, EBITDA endeavors to showcase the cash profit flowing from a company's core operations.

However, it's important to note that EBITDA doesn't play by the rules of generally accepted accounting principles (GAAP). Some daring public companies, seeking to dazzle investors, showcase EBITDA alongside adjusted figures, often excluding additional costs like stock-based compensation from the limelight.

As the spotlight intensifies on EBITDA in the corporate and investor arenas, criticisms surface, suggesting that it might exaggerate profitability. To keep the financial stage honest, the U.S. Securities and Exchange Commission (SEC) steps in, requiring companies to reveal the derivation of EBITDA figures from net income and forbidding the reporting of EBITDA on a per-share basis.

EBITDA Formulas: The Dance of Numbers
For those keen on decoding financial statements, calculating EBITDA is like uncovering the secrets of an ancient script. If a company doesn't readily reveal its EBITDA, fear not! You can summon it from the depths of financial statements.

There are two enchanting EBITDA formulas, both weaving a tale of financial prowess. One formula, based on net income, and the other on operating income, both lead to a similar result. The dance of numbers begins:

EBITDA = Net Income + Taxes + Interest Expense + D&A


EBITDA = Operating Income + D&A

(D&A stands for the mystical realm of Depreciation and Amortization.)

Understanding the Magic of EBITDA

EBITDA, by adding back interest, taxes, depreciation, and amortization to net income, allows us to track and compare the underlying profitability of companies. It's like donning a pair of enchanted glasses that reveal a company's true financial essence, irrespective of its depreciation assumptions or financing choices.

In the grand ballroom of valuation ratios, EBITDA often waltzes hand in hand with enterprise value, creating the mesmerizing EV/EBITDA, also known as the enterprise multiple.

But wait, there's more! EBITDA finds its greatest magic in asset-intensive industries, where the abundance of property, plant, and equipment casts a spell of high non-cash depreciation costs. It becomes a beacon of clarity, cutting through the fog that obscures changes in underlying profitability, such as in the mystique of energy pipelines.

Meanwhile, in the realm of software development and intellectual property, EBITDA takes center stage, allowing early-stage technology and research companies to showcase their performance sans the veil of amortization.

EBITDA's Historical Odyssey: A Tale by John Malone
Enter the historical stage, where EBITDA makes its grand entrance. Crafted by the visionary John Malone, Chairman of Liberty Media, in the 1970s, EBITDA emerged as the secret weapon in his arsenal for selling lenders and investors on his leveraged growth strategy. This strategy, combining debt and reinvested profits to minimize taxes, set the stage for EBITDA's grand entrance into the financial narrative.

During the 1980s, the era of leveraged buyouts (LBOs), EBITDA found its way into the hearts of investors and lenders. It became a trusted companion, estimating the profitability needed to service the expected debt in acquisitions. As a metric that excluded interest and tax expenses, EBITDA became the shining star in assessing a company's ability to navigate debt service costs.

Yet, like any hero, EBITDA faced its share of challenges. The dotcom bubble witnessed its misuse, with some companies wielding it to exaggerate their financial performance. In 2018, WeWork's "Community Adjusted EBITDA" in its IPO prospectus raised eyebrows, adding a twist to EBITDA's historical journey.

Criticisms of EBITDA: Unveiling the Dark Corners

As with any powerful spell, EBITDA has its skeptics and naysayers. The criticisms echo through the financial corridors:
  • EBITDA Ignores Asset Costs: A common gripe is that EBITDA paints an incomplete picture, ignoring the cost of assets. It's as if profitability were a magic trick solely fueled by sales and operations, overlooking the tangible assets and debt financing that shape a company's destiny.

  • Earnings Figures May Be Suspect: The simplicity of EBITDA formulas masks the potential for earnings accounting games. Different companies use different earnings figures as the starting point, rendering EBITDA susceptible to financial sleight of hand.

  • Company Valuation Can Be Obscured: The exclusions in EBITDA can cast a deceptive veil over a company's true value. Stock price multiples of EBITDA, rather than bottom-line earnings, might produce lower multiples, creating illusions of a less expensive entity.

As the sage Warren Buffett once remarked, "References to EBITDA make us shudder." To him, depreciation is a real cost that cannot be ignored, and EBITDA fails as a "meaningful measure of performance."

EBITDA vs. EBIT vs. EBT: A Dance of Financial Terms
As we navigate the financial dance floor, it's crucial to understand the intricate steps of EBITDA, EBIT, and EBT. Earnings before interest and taxes (EBIT) takes a bow, representing a company's net income plus income tax and interest expenses. EBIT unveils the core operations' profitability.

Moving to Earnings Before Tax (EBT), it reveals how much operating profit has been realized before accounting for taxes. EBIT, being the star that excludes both taxes and interest payments, lays the groundwork for assessing a company's performance.

While EBITDA, EBIT, and EBT don't shy away from the non-cash expenses of depreciation and amortization, each plays a unique role in the financial ballet.

EBITDA vs. Operating Cash Flow: Unveiling the True Cash Sorcery
In the quest for true financial clarity, operating cash flow emerges as a worthy companion. Unlike EBITDA, operating cash flow provides a genuine measure of how much cash a company generates. It adds back non-cash charges like depreciation and amortization to net income while including changes in working capital.

However, the true magic lies in the nuances of working capital trends. Investors, relying solely on EBITDA, might miss crucial clues, like challenges with receivables collection, that can impact cash flow.

In Conclusion
As the curtain falls on our journey through the mystical world of EBITDA, one truth remains: EBITDA is a tool, a measure, a lens through which we glimpse a company's financial narrative. It can be powerful, but like any magic, it requires discernment. Critics may cast shadows, but the key lies in reading the fine print, understanding the alchemy that transforms EBITDA into net income. In the grand saga of finance, EBITDA remains a protagonist, a character in the unfolding story of profitability, waiting to be understood, questioned, and embraced with discernment.

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