The EBITDA is a financial indicator that shows an approximation to the cash flow generated by the company in its operation, that is why it is one of the indicators preferred by credit analysts to evaluate the debt capacity of the company and the risk rating agencies to issue its opinion.
To calculate the EBITDA, we must refer to what each of the letters that compose it means.
E = Earnings
B = Before
I = Interests
T = Taxes
D = Depreciation and
A = Amortization
The EBITDA is the Profit before interest, taxes, depreciation, and amortization. But what does this mean? In short, to obtain the EBITDA, the expenses reported for depreciation and amortization must be added to the operating profit, in other words, the lower values of the profit that were not cash outflows are returned to the profit. With this adjustment is possible to reconcile a proxy of the cash flow generated by the company in a certain period.
Example: Calculate EBITDA for a company that had sales of $ 1 billion, an operating profit of $ 200 million, has depreciation expense of $ 10 million, amortization costs of $ 5 million, and a net income of $ 70 million.
EBITDA = Operating Income (EBIT) + Depreciation + Amortization
EBITDA = 200 + 10 + 5 = 215
You already know its definition, now we are going to break down each step so that you learn how to make the best possible analysis of this indicator.
To have a correct vision of the company’s cash flow we must consider some adjustments. Profit before taxes and interest is that which is obtained on a recurring basis from the development of the company’s corporate purpose. To a certain extent, it is like operating income, which is the result of income minus costs and less administrative and sales expenses. As mentioned at the beginning of this paragraph, you have to focus on the recurring benefits, this means that those expenses and income that will not be repeated in future periods should be excluded from the profit value.
An analyst should not be able to consider income from the sale of an asset as something that will appear in future years since it would be inflating income expectations beyond what would be considered probable. Whenever you do a financial analysis, remove those expenses or income that will not be received again. If the company had a loss due to the payment of a fine, it is likely that this will not be paid again, so the company should be analyzed excluding this payment.
About depreciations, these are a lower value of an asset that is recognized for its wear and tear. Depreciation is an expense in the Income Statement and a lower value of the asset in the Balance Sheet. That is why when adding depreciation to Profit before interest and taxes, you get closer to the real cash generation of the company.
The EBITDA is more important in industrial companies with a large amount of fixed assets, in this type of company the depreciation expense is usually high, so the operating profit does not show the reality of the resources generated by the company.
In the case of amortizations, the same happens as with depreciations, they decrease the profit, although it has not implied a cash outflow.
Amortizations are usually given for prepaid expenses that must be expensed at the time they are incurred. For example, insurance paid in advance for 5 years, although the cash has already been used for payment at the initial moment, for the following years this expense must be recognized in the income statement and profit must be reduced. In this case, this recognition of expenses does not imply the outflow of cash and that is why amortizations are added.
I hope that with this explanation it becomes much clearer why EBITDA is the cash approximation of a company. You will return non-cash outflows to the recurring profit generated by the operation (depreciation and amortization) and it will give us a look at the real company’s performance.
What is EBITDA used for?
By giving an appreciation of cash generation, it becomes relevant when evaluating the debt and payment capacity of a company. Indicators such as DEBT to EBITDA ratio and EBITDA/financial expenses are widely used to determine the credit quality of a company.
The DEBT/EBITDA ratio tells you how many years it would take a company to pay its debts only with the generation of EBITDA. The lower the better and when it exceeds 4 times, rating agencies and banks are already beginning to warn about high levels of leverage.
The EBITDA/Financial Expense indicator shows how much EBITDA is generated to pay interest on the debt, giving you a look at the short-term payment capacity.
