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MBA Mondays: EBITDA

One word I hear a lot in the finance world is EBITDA.  Most people don’t know how to pronounce that acronym, let alone how to define or calculate it.   But it’s quite an important concept in business.

Investopedia defines EBITDA as net income with interest, taxes, depreciation, and amortization added back to it, and can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions.

EBITDA first became common in the 80s with respect to leveraged buyouts, because banks and finance firms used it calculate whether or not a company could service its debt, based on how much money it earned.

The simple way I like to think about EBITDA is earning power. It is the profit that a company earns for doing exactly what it’s supposed to: sell a product or a service.

EBITDA effectively removes the effect of things people don’t want to consider – the effects of taxes, interest income, and expense as well as the effects of capital investments e.g. depreciation and amortization.  In other words, EBITDA is a measure of a company’s financial performance sheltered from the real world since all companies actually are impacted by those.

Because EBITDA helps measure the company’s underlying profit, it is often very important.

Banks use EBITDA when determining how much money they can lend (e.g. if a company can service its debt).

Private Equity firms use EBITDA to compare companies across the world which have different capital structures.

M&A teams use it to come up with valuations for companies to acquire or sell.  These figures often go into their financial reports.

Lawyers and investment bankers use it to create earn-out provisions. An earn-out provision is an arrangement in which sellers of a business could receive an additional future payment (beyond the selling price), usually based on future earnings or the satisfaction of other conditions. (This term deserves more explanation, stay turned for a future post on this).

Executive compensation consultants use EBITDA to help determine long-term incentives of executives and CEOs.  The higher EBITDA is, the higher the incentive payment the CEO receives.

The list goes on and on.  It’s probably worth learning more about this important term if you want to succeed in finance.

1 Comment to MBA Mondays: EBITDA

Yung Chan
July 2, 2013

Great information. Thanks! ^_^

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