EBITDA is a commonly used acronym for a representation of profits. The letters stand for Earnings before Interest, Taxes, Depreciation and Amortization.
EBITDA indicates the maximum amount of cash flow from a business’ operations that is available to be reinvested in the business, service debt by paying interest and repaying principal and provide a return on investment to the owners. EBITDA is the starting point to determining the value of a business and certainly not the only way.
The earnings are the bottom line on the statement of operations – the net income. The other components are deductions that are added back to determine an adjusted profit or cash flow from revenues, i.e. EBITDA. Interest is the amount paid to lenders. Note that each owner would have different capital and debt configurations so the add-back sort of creates a uniform playing field. One owner could decide to have no debt while another would want as much as possible making interest payments a function of an ownership decision regarding leverage and not an operational issue. Taxes are paid on profits and are not a measure of operations. Further, taxes are not always consistently applied and depend upon management decisions about debt and level of aggressiveness toward tax elections and credits and possibly the business’ physical location. Depreciation and amortization are not cash expenditures but the systematic writing off of current and prior capital expenditures.
EBITDA gives the starting point to determine the real cash flow from operations and is applied to the following items:
- Funding growth in accounts receivable and inventory in excess of the account payable
- Acquiring capital assets such as machinery, equipment, technology and possibly new facilities or leasehold improvements
- Applying the funds to decrease leverage, i.e. reliance on lenders, and building up the equity capital in the business
- Accumulating funds for future anticipated needs and to fuel growth
- Interest on loans
- Loan principal repayment
- Income taxes
- And finally, payments to owners or investors
Valuing a business or providing for the future involves judgments about the continuance of the present mode of operations, anticipated changes and growth, future conditions and projections of liquidity and cash needs. It is, at its best, a best guess at that moment of time and because of that, needs to be considered on the side of caution. So use EBITDA when you start but don’t confuse it with the ending point.
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