Investors and analysts use EBITDA to talk about profit. But relying on EBITDA alone ignores critical uses of cash that appear elsewhere – capital spending, changes in working capital, deferred revenue. In many cases, a company with a high EBITDA may also have very little net income and only by looking at both net Income and EBITDA together gives a complete picture.
The abbreviation EBITDA means different things to different people. At its most simple, the financial metric which stands for Earnings Before Interest, Tax, Depreciation and Amortisation, is a measure of a company’s profitability and shows how much money it has made before interest, taxes, depreciation and amortisation have been deducted.
It ignores interest charges, enabling comparisons between companies that have different capital structures. And by excluding taxes, it also makes it possible to compare companies in different countries which may be subject to different tax regimes.
However, EBITDA is also seen as an unreliable measurement for a number of reasons. It is not defined by Generally Accepted Accounting Principles (GAAP) and is therefore susceptible to manipulation by companies that want to make their earnings look stronger than they are. Different companies may define amortisation and depreciation in different ways, and companies can even change the way in which EBITDA is measured in different reporting periods.
Other criticisms include the fact interest and tax can be significant costs; it is misleading to exclude them from a measurement of profitability. It doesn’t take capital expenditure required to replace short-lived assets into account, and critics say EBITDA is therefore more appropriate as a measurement of companies with long-lived assets. Nor are fluctuations in working capital measured by EBITDA.
In a recent posting Asif Masani, Financial Planning and Analysis Manager at training and development provider Coursera in Mumbai threw additional light on the metric, particularly around the differences between EBITDA and net income. EBITDA is used as an indicator to determine the total earning potential of a company and many investors believe high EBITDA is indicative of a strong company. “This may not always be the case,” he wrote.
High EBITDA; low net income?
In many cases, a company with a high EBITDA may have very little net income. “EBITDA is an indicator that calculates the profit of the company before paying the interest, taxes, depreciation, and amortisation. Net income is an indicator that calculates the total earnings of the company after paying the interest expenses, taxes, depreciation and amortisation,” he wrote.
Net income is used to determine the company’s earnings per share, he continues. “EBITDA can be measured by adding depreciation and amortisation to EBIT or by adding interests, taxes, depreciation, and amortisation to net profit. Net income, on the other hand, is calculated by subtracting revenue from the overall cost of doing the business.”
While EBITDA is used for start-up companies to see how they perform, net income is used pervasively in all circumstances to understand financial health. However, EBITDA is used to find out the earning potential of a company. “That’s why investors calculate EBITDA when they look at a new company. EBITDA is also pretty easy to use since no depreciation and amortisation is involved.”
Net income is also used to find out the earnings per share (EPS) if the company has issued any shares. By dividing the net income by the number of shares outstanding we can get the EPS. “Only by looking at both net Income and EBITDA together gives you a complete picture,” he concludes.
