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EBITDA
Earnings Before Interest, Taxes, Depreciation and Amortization. An approximate measure of a companys operating cash flow based on data from the companys income statement. Calculated by looking at earnings before the deduction of interest expenses, taxes, depreciation, and amortization. This earnings measure is of particular interest in cases where companies have large amounts of fixed assets which are subject to heavy depreciation charges (such as manufacturing companies) or in the case where a company has a large amount of acquired intangible assets on its books and is thus subject to large amortization charges (such as a company that has purchased a brand or a company that has recently made a large acquisition). Since the distortionary accounting and financing effects on company earnings do not factor into EBITDA, it is a good way of comparing companies within and across industries. This measure is also of interest to a companys creditors, since EBITDA is essentially the income that a company has free for interest payments. In general, EBITDA is a useful measure only for large companies with significant assets, and/or for companies with a significant amount of debt financing. It is rarely a useful measure for evaluating a small company with no significant loans. Sometimes also called operational cash flow.
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Earnings Before Interest, Taxes, Depreciation, and Amortization - EBITDA
An indicator of a companys financial performance calculated as
= Revenue - Expenses (excluding tax, interest, depreciation, and amortization)
EBITDA can be used to analyze the profitability between companies and industries, because it eliminates the effects of financing and accounting decisions.
A common misconception is that EBITDA represents cash earnings. EBITDA is good metric to evaluate profitability, but not cash flow.
EBITDA first came into common use with leveraged buyouts in the 80s, where it was used to indicate the ability of a company to service debt. As time passed, it became popular in industries with expensive assets that had to be written down over long periods of time. Lately, EBITDA is commonly quoted by many industries, especially technology, even when it isnt warranted. Consequently, EBITDA is frequently being used as an accounting gimmick to dress up a companys earnings.
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EBITDA The Good, The Bad, and The Ugly
EBITDA is one of those terms that is getting increased usage but usually for the wrong reason. This article will define it and discuss how it can be useful but also misleading.
EBITDA is an abbreviation for earnings before interest, taxes, depreciation and amortization. It is calculated by taking operating income and adding back to it interest, depreciation and amortization expenses. EBITDA is used to analyze a companys operating profitability before non-operating expenses (such as interest and other non-core expenses) and non-cash charges (depreciation and amortization).
The Good
EBITDA can be used to analyze the profitability between companies and industries. Because it eliminates the effects of financing and accounting decisions, EBITDA can provide a relatively good apples-to-apples comparison. For example, EBITDA as a percent of sales (the higher the ratio, the higher the profitability) can be used to find companies that are the most efficient operators in an industry.
The ratio can also be used to evaluate different industry trends over time. Because it removes the impact of financing large capital investments and depreciation from the analysis, EBITDA can be used to compare the profitability trends of, say, heavy industries (like automobile manufacturers) to hi-tech companies.
The new accounting rules that eliminate the amortization of goodwill, formally know as FAS 14, will bring operating income closer to EBITDA, but EBITDA will continue to be a better measure of core operating profitability.
The Bad
EBITDA is good metric to evaluate profitability but not cash flow. Unfortunately, however, EBITDA is often used as a measure of cash flow, which is a very dangerous and misleading thing to do because there is a significant difference between the two.
Operating cash flow is a better measure of how much cash a company is generating because it adds non-cash charges (depreciation and amortization) back to net income and includes the changes in working capital that also use/provide cash (such as changes in receivables, payables and inventories). These working capital factors are the key to determining how much cash a company is generating. If investors do not include changes in working capital in their analysis and rely solely on EBITDA, they will miss clues that indicate whether or not a company is losing money because it cannot sell its products!
The Ugly
It gets ugly when EBITDA is used as a key measure for making investment decisions. Because it is easier to calculate, EBITDA is often used as a headline metric in discussing a companys results. This, however, could, as discussed above, misrepresent the true investment potential of a company because it does not accurately reflect a firms ability to generate cash.
DEFINATION OF TERMS
1. Corporate Tax
A levy placed on the profit of a firm; different rates are used for different levels of profits.
. Depreciation
1. An expense recorded to reduce the value of a long-term tangible asset. Since it is a non-cash expense, it increases free cash flow while decreasing the amount of a companys reported earnings.
. A decrease in the value of a particular currency relative to other currencies.
. Amortization
The paying off of debt in regular installments over a period of time.
The deduction of capital expenses over a specific period of time. Similar to depreciation, it is a method of measuring the consumption of the value of long-term assets like equipment or buildings.
Think of this as claiming the decrease in value on your car every year. If you bought your car new for $0,000 and after the first year it is worth $17,000 theoretically you could amortize the $,000 for tax and financial purposes.
4. FAS � 14 New Accounting Rules Could Roil the Markets
Financial Accounting Standards Board - (FASB)
Designated as the organization for establishing standards of financial accounting and reporting. FASB standards govern the preparation of financial reports and are recognized by the SEC.
Accounting standards are crucial in an efficient market, as information must be transparent, credible, and understandable. The FASB sets out to improve accounting practices by enhancing guidelines set out for accounting reports, identifying and resolving issues in a timely manner, and creating a uniform standard across the financial markets.
FAS � 14 is the new accounting rule that changes the way companies treat goodwill, and, to avoid making bad investment decisions, investors MUST be aware of its impact on reported earnings. This accounting rule change will impact earnings two main ways, both of which could give uninformed investors a wrong signal
1. The change will generate a one-time boost to EPS that could fool the market into thinking it represents a change in the fundamentals.
. The new rules also provide an incentive to write-off goodwill during the next few quarters, which will further depress weak earnings.
Previously, companies were required to amortize goodwill over a long time (40 years), and this non-cash expense reduced reported (GAAP) EPS. FAS 14 eliminates amortization and instituted an annual impairment test. This article will briefly review the potential impact of these changes on reported earnings. We expect the changes to start impacting earnings by the end of this year.
EPS Impact A Potential False Positive
The new accounting change will provide a one-time boost to a companys EPS, which may be misinterpreted by the market as an improvement in the long-term earnings potential of the company, causing the market to move the stock higher. There is also the possibility that the market may react like it does when a company announces a stock split, bidding the shares higher although no change occurs in the fundamental earning power of the company. One Wall Street analyst recently estimated that this change could boost software firms EPS by 114%.
In reality, however, a companys fundamentals, real earnings potential, and cash flows remain unchanged regardless of the new rules. FAS 14 can be viewed as a rule change that occurs in the middle of the game. But because companies are not required to restate historical results, the change will potentially result in significant EPS growth in the first quarter after adoption of the rule. During the next three quarters, while EPS growth will be exaggerated when it is compared to the same quarter of the prior year, sequential EPS growth will fall back to lower (normal) levels.
After the dismal earnings reported in this year, this sudden acceleration of EPS growth may generate a knee-jerk reaction in the market, causing these shares to rise. Under this scenario, uninformed investors may get caught up in the excitement and could lose money as they chase what they think is strong earnings growth.
Ironically, the companies that may experience the greatest EPS growth from this change are the old dotcom darlings. Internet and telco companies whose earnings have evaporated (did they ever exist?) could post significant EPS growth as they eliminate the amortization of the huge amounts of goodwill they accumulated during the heady times when all-stock mergers were done at outrageous multiples. Hopefully these companies will resist the temptation to use this as an opportunity to generate renewed interest in their tired shares. (Not!)
5. Cash Flow
The amount of cash a company generates and uses during a period, calculated by adding noncash charges (such as depreciation) to the net income after taxes. Cash Flow can be used as an indication of a companys financial strength.
It is also sometimes referred to as the money value of trades in a stock during a trading day.
Cash flow is crucial to companies, having ample cash on hand will ensure that creditors, employees, and others can be paid on time.
EBITDA
Definition EBITDA is an abbreviation for Earnings before Interest, Tax, Depreciation and Amortization. It reports what the company would have earned during the period if it did not have to pay interest on its debt; didnt have to pay taxes; and had depreciated the full value of all assets at their acquisition.
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It is roughly equivalent to the Operating Income line in the Income Statements.
Also Known As Earnings before Interest, Tax, Depreciation and Amortization
Earnings before Interest, Tax, Depreciation and Amortization - EBITDA
Earnings Before Interest, Tax, Depreciation and Amortization - EBITDA
EBITDA tells an investor how much money a company would have made if it didn't have to pay interest on its debt, taxes, or take depreciation and amortization charges. EBITDA is intended to be an indicator of a company's financial performance, not free cash flow as many investor incorrectly assume, originally coming into existence in the 180's during the leveraged-buyout frenzy that epitomized the era of greed. The measurement has become so popular that many companies will boast charts and graphs of their increased EBITDA within the first five pages of their annual report. Investors, thinking this is wonderful, get excited about the business because it appears to be growing in leaps and bounds.
In its brilliance, Wall Street regrettably forgot one part of the equation common sense. Companies do have to pay interest, taxes, depreciation, and amortization. Treating these expenses like they don't exist is the same mentality of the five year old who believes no one can see them when their eyes are closed � while they may enjoy pretending for a while, the IRS and the banks and bondholders who lent money to the company aren't interested in playing games. When the bills come due, these entities want the money owed to them and can force bankruptcy if they aren't paid.
Still not convinced? Picture this scenario
A single man in his mid-twenties, earning $0,000 annually, walks into his local bank to get a loan for a new, top-of-the-line BMW. Each year, he pays $8,100 in taxes, reducing his monthly check from $,500 to $185 [for simplicity sake, lets ignore payroll deductions, etc.] He currently has a mortgage payment of $1,100 per month, and a student loan payment of $00 per month. After paying all of these expenses, he has $55 on which to live.
The loan officer crunches the numbers and comes up with an estimated monthly payment of $750 for the car. The man pulls out his pen to sign the papers. The loan offer looks in confusion after reviewing his information. "Sir," she says, "you only make $55 a month after payments and taxes! You can't afford this loan. Not only can you not afford the payment, you will then have nothing to live on." The man looks confused, "but I make $,500 per month before my payments and taxes."
See the fallacy? The gentlemen in our example may ignore the loans, but his creditors surely aren't. In fact, the officer would probably laugh at him. Sadly, this is exactly what corporations are doing by presenting their EBITDA numbers to investors.
The truth is, in virtually all cases, EBITDA is absolutely, entirely, and utterly useless. It is simply a way for companies that can't make money to dress-up their failures by reporting increased something to investors. When the traditional metric of profit couldn't be attained, they created a new one that made them appear successful.
In the accounting and business world, EBITDA is a firestorm of controversy. There are some who will defend it vehemently, and attempt to ridicule you for even suggesting it isn't worth the time it takes to pronounce the letters. Often, these people will appear to be very intelligent, driven, and professional. Don't worry about it � four hundred years ago, the brightest men on earth thought the world was flat. Smile and say a prayer of thanks because it's folly such as this that presents us with opportunity to profit in the market.
EBITDA Still relevant in the wake of WorldCom?
With recent accounting scandals with the likes of Enron and WorldCom, investors are beginning to focus more diligence on just how the financial statements of their favourite companies are constructed. One commonly reported measure from a company's income statement that has come under abrupt scrutiny with the WorldCom scandal is that of Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA).
As its long-form title suggests, EBITDA is a company's reported profit before the non-cash charges of depreciation and amortization, and the very-much-cash charges of interest and taxes.
EBITDA first came into use in the 180's with the leveraged buyout craze, where it was used to indicate the availability of earnings to service the interest on a company's debt. More recently, EBITDA has been put to use among telecommunications, cable-TV and wireless companies, who spend enormous sums on building infrastructure, then write down those assets over a long period of time. EBITDA takes away the often-enormous depreciation and amortization charges associated with asset write-downs, and makes companies' earnings reports look better with the remnants of asset building removed.
Whether it is interest or depreciation, using EBITDA alone as a performance measure clearly leaves out a great deal of essential information that investors would be quite interested to know. In the case of WorldCom, the company exploited the EBITDA measure by improperly booking $.8 billion in 001 operating costs as capital expenditures, which are listed on the balance sheet and can be depreciated over time, thereby removing them from reported earnings and inflating the company's EBITDA.
Should EBITDA Be Discarded?
Even in the wake of the accounting shenanigans, the balance of opinion as to the continuing utility of EBITDA has not yet swayed strongly in any one direction. A recent CNN Money article reports EBITDA is particularly useful when you have companies with big capital investments, heavy up-front costs where it takes a while to get returns back, says Chuck Hill, director of research for First Call.
Offering a contrary view in a recent TheStreet.com article, The Company and its public relations and the analysts push you to look at the EBITDA and take you away from focusing on the negative issues which might be more prevalent by looking at the cash flow statement, said Richard Mole, CPA and partner at Weisberg Mole Krantz & Goldfarb.
EBITDA-based valuations and the high-capex nature of the cable business reignited concerns that cable companies could also be overcapitalizing expenses and overstating EBITDA, Merrill Lynch analyst Jessica Reif Cohen wrote in a recent research report.
We believe the accounting concerns seem overblown, she added. While there are slight variances in accounting in accounting policies among many companies in the cable industry, we believe the differences are slight. It is our understanding that cable operators all follow generally accepted accounting practices, except Adelphia.
But Reif Cohen emphasized that the cable business derives much of its revenues from subscription fees, leading to very consistent and highly predictable revenue and EBITDA results.
With mixed expert advice as to the continued use of EBITDA, the only conclusion for investors is to exercise extreme care when using the measure for their own analyses. As with any other financial measure or ratio, EBITDA should only be used in conjunction with many other fundamental indicators to develop a full picture of a company's operations and prospects. Only then can investors hope to begin protecting themselves from falling for inappropriate use of a single measure used alone.
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