A widely used and often misunderstood way of tracking a business’ performance is to look at its EBITDA. What is this?
The acronym stands for Earnings Before Depreciation, Interest, Tax & Amortisation. But what is it actually telling us?
Earnings is another word for ‘Profit’. So EBITDA is basically your profit for the period before deducting certain costs.
These costs include interest and tax because these are usually outside of the control of the managers of a business. The tax charge will only apply if the business makes a profit and the level of the charge is decided upon by the government. Interest levels are set by the lender and most business managers will not have been responsible for taking out the loans that created the interest.
The depreciation charge is caused by having fixed (or non current) assets and again most business managers will not have authorised the purchase of these fixed assets in the first place.
The amortisation charge is caused by having intangible fixed assets like licences, patents & goodwill (amortisation is like depreciation but for intangible rather than tangible assets). Most business managers will not have been responsible for investing in these intangible assets.
So what we are doing in assessing a business using the EBITDA measure is looking at the profits of the business before deducting all of the costs that the business manager cannot control. EBITDA shows us how well the manager has performed in their role as manager.
In this sense EBITDA might be said to give us a misleading and overly optimistic view of the business itself (rather than the manager’s performance) as it excludes the key cost of depreciation.
Those in favour of EBITDA’s use would state that EBITDA is a quick way to get a feel for how much cash the operations of the business have generated in the year. Some organisations even refer to EBITDA as being the company’s ‘Free Cash Flow’ for the year.
Whatever the arguments for and against its use, EBITDA is commonly used by financial commentators and companies themselves as the primary indicator of their financial performance for the year.
If you would like to know more about EBITDA, have a look at the Business Videos tab on our site where there is a video entitled ‘Other Financial Terminology’ which gives more detail on EBITDA