Top Stories | Thu, 12 Dec 2024 12:39 PM

Top interview Q&A on EBITDA

Posted by : SHALINI SHARMA

EBITDA or Earnings Before Interest, Taxes, Depreciation, and Amortization is one of the most significant financial indicators providing a very lucid view of the operational profitability of a company. It contrasts from net income since the computation of EBITDA eliminates financing costs, accountancy costs, and any kind of non-cash cost thereby providing an extremely sharp insight into the performance of a business. This measure is very useful in comparing companies belonging to the same industry since it washes out the effect of different capital structures and accounting practices.

For companies, an EBITDA margin shows efficient operating and cash flow generation, the basis for reinvestment and servicing of debt. EBITDA, on the other hand, cannot be used to measure actual cash flow because it fails to take into account changes in working capital as well as capital expenditures. Critics argue that it sometimes obscures the underlying financial problems that exist, such as high levels of debt or poor cash management, by not taking into account interest and tax burdens.

Basically speaking, in principle, EBITDA provides a useful instrument when one analyzes the operating effectiveness or profitability, but the practice always correlates other financial performance indicators in utilization.

1. What is EBITDA and why is it important?

 EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is one of the most frequently used financial measures for measuring a company's operational profitability, not taking into consideration financing costs in the form of interest and tax liabilities as well as non-cash expenses like depreciation and amortization.

EBITDA is important because:

It gives a clear picture of the performance of the core operations of a company.

It eliminates the effects of capital structure, accounting policies, and tax jurisdictions; hence, it becomes easier to compare companies of an industry or region

It is an efficient manner of judging the ability of the company to generate cash from its business activities which is very important for reinvestment and debt repayment.

2. How is EBITDA calculated? With examples.

 There are two simple formulas to calculate EBITDA: 

(i) From Net Income:

EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization

(ii) From Operating Income (EBIT):

EBITDA = Operating Income + Depreciation + Amortization

Example: The following data are available for a company.

Net Income is $500,000, Interest Expense is $50,000, Tax Expense is $100,000, Depreciation is $70,000, Amortization is $30,000 

Calculation of EBITDA:

EBITDA = $500,000 + $50,000 + $100,000 + $70,000 + $30,000 = $750,000

This is the earnings of the firm without financing, taxes, and non-cash costs.

3. What is the purpose of eliminating interest, taxes, depreciation, and amortization from EBITDA?

These are eliminated to focus on the operational efficiency and profitability of the business.

Interest: Eliminated because it deals with the financing structure of the company, which is quite different from one company to another.

Taxes: These are excluded as the tax policies vary from place to place and thus it cannot reflect the operating performance.

Depreciation and Amortization: These are non-cash items representing the accounting conventions of spreading costs over long-term assets. The exclusion of these would show the cash-generating capability of the business.

These variables stripped out way to EBITDA to provide a "clean" measure which would compare companies on apples-to-apples basis.

4. What are the benefits of using EBITDA?

Some of the most significant benefits of EBITDA include:

Focus on Core Operations: It separates the income derived from business operations, irrespective of financing and accounting techniques used.

Easy Comparison: Easy to compare companies of similar business. No consideration given for capital structure or differences in regional tax.

Indicator of Cash Flow Potential: EBITDA does not represent the cash flows but indicates as to how much cash is possible for a company to generate that will be consumed for servicing debt and reinvestment.

Extensively Used Measure: It is widely adopted by analysts, investors and creditors to measure business performance.

5. What are the limitations of EBITDA?

Though useful EBITDA is handicapped by one disadvantage:

Not a Cash Flow Measurement: It does not reveal the fluctuations in working capitals, capital expenditures, and other major cash uses that might have a bearing on the statement of financial condition.

Debt burden with tax burden does not feature, and that has a healthy look from an EBITDA perspective over the financially companies that has the debt burden and tax obligation.

Risk of Over-reliance: Overuse veils inefficiencies, not least costs incurred for running such operations and poor cash management.

Deception in Capital-Intensive Industry: Industries like manufacturing would appear highly profitable as the company will derive an important cost called depreciation excluded in computing EBITDA.

6. What is the difference between EBITDA and EBIT?

 EBIT, or Earnings Before Interest and Taxes, is an earnings measure that incorporates the effects of depreciation and amortization but eliminates the impact of interest and tax.

Key Difference:

EBIT (Operating Income) = EBITDA - Depreciation - Amortization

EBITDA= Operating Income + Depreciation + Amortization

Comparison:

EBIT: Is used to help understand the profit if one were to restore all the depreciation and amortizations from assets

EBIDTA: It also gives the potential of operational cash flow but insensitive towards the non-cash expenses related to the asset

7. What are the common financial Ratios involved in EBIDTA?

 Generally applicable on other ratios which contain denominator of EBITDA, like for example:

Enterprise value to EBIDTA (EV/EBIDTA):

This one compares Total business firm value to the Enterprise by using EBITDA.A high valuations may provide an attractive investment.

Enterprise Valuation / EBITDA Formula =Enterprise value/ EBITDA.

Debt-to-EBITDA Ratio:

It measures how much a firm can support its debt through operational earnings. A lower ratio reflects greater coverage of debt

Formula: Debt-to-EBITDA = Total Debt / EBITDA

EBITDA Margin:

EBITDA Margin is the percentage of revenue retained as EBITDA. The more the higher, the higher the marginal operating efficiency

Formula: EBITDA Margin = (EBITDA / Revenue) × 100

8. Is EBITDA a good measure of profitability?

 EBITDA is a useful but not a comprehensive measure of profitability. It reveals the operational performance by eliminating the impact of financing, taxes, and non-cash charges. It does not give a complete picture since:

 It has not included the essential cost interest and taxes.

It did not take into consideration cash required for working capital or capital expenditures.

EBITDA should always be used in concert with other metrics, such as net income and free cash flow, to get a balance view.

9. Why is EBITDA used so widely in mergers and acquisitions (M&A)?

 EBITDA is very frequently used in M&A deals because:

It offers normalized means of evaluating the operating profitability of companies that remove various items like financing and tax structures.

Buyers will use EBITDA as an estimate of the firm's ability to generate cash which is critical to determining whether or not the firm can absorb debt that was taken on during the acquisition.

It decomplicates comparisons of potential targets for acquisition, meaning buyers will focus on business performance

In valuation multiples such as EV/EBITDA are often applied to estimate the purchase price.

10. What are some practical criticisms of using EBITDA?

 In practice, EBITDA may be criticized as overly optimistic because it ignores significant expenses and cash requirements. Some examples of the same are given below:

Can Mask Financial Issues: High EBITDA may present a company as profitable even though it has high debt levels or low cash flow.

Not Standardized Everywhere: EBITDA does not have any specific definition under both GAAP and IFRS; therefore, it leaves the calculation a little to the discretion of each, hence different methods.

Too Much Dependency on EBITDA Multiples in Value Analysis: It is too heavily reliant on EBITDA multiples, which will present the value of the firm falsely in capital-intensive sectors.