Earnings before interest, tax, depreciation, and amortisation (EBITDA) has two main uses:
- as a comparison over time of the profitability of a company's operations without the potentially distorting effects of changes in depreciation, amortisation, interest and tax
- to calculate EV/EBITDA, a valuation ratio free of these distortions, allowing fair comparisons of companies with different capital structures.
Interest and tax are excluded because they include the effect of factors other than the profitability of operations. Interest is a result of the company's financial structure. Depreciation and amortisation (and depletion, when it appears) reflect the accounting treatment of past purchases and are unrelated to future cash flows, and future cash flows are what ultimately matter to investors.
EBITDA is calculated simply by adding back each of the excluded items to the post-tax profit, which is shown on the P & L.
As EBITDA is an adjusted profit number it is usual to state it before exceptional items.
EBITDA can also be regarded as a measure of underlying cashflow. It is closely related to operating cash flow. The difference is that operating cash flow includes the effects of changes in working capital). EBITDA can therefore be used as a measure of underlying cash flow (i.e. stripping out the volatile effects of changes in working capital).
The merits of EBITDA
There is a lot of disagreement about the usefulness of EBITDA. The argument against it is that depreciation and amortisation, and even more interest and tax, reflect real expenses, that should not be ignored.
The argument in favour of it is that the expenses it ignores are either sunk costs, or are dependent on a company's capital structure: EBITDA is used in ratios that can allow one to compare companies with very different capital structures.