What is EBITDA? Meaning, Formula & Importance for Investors

EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortisation, is a financial metric that helps evaluate a company's operational performance. 

For example, if a company earns ₹10 crore in revenue and ₹3 crore of that goes into core operating profit before taxes and interest, the EBITDA provides a clearer picture of actual operational profitability.

In this blog, let’s walk through a simple yet informative story about two friends, Rajat and Sneha, who started analysing financial reports for investment. Their journey explains why EBITDA matters to anyone investing in businesses.

What is EBITDA?

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortisation. It strips out expenses that can vary depending on accounting choices and capital structure, giving a clearer view of core profitability.

Why It’s Useful:

• Focuses on operating profitability
• Useful for comparing companies in the same sector
• Ignores financing and non-cash accounting differences

Example: Let’s look into the bifurcation of the revenue and the expense of ABC company.
 

EBITDA Formula and Calculation

The basic EBITDA formula is: EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortisation

Alternatively, if you know Operating Profit (EBIT):
EBITDA = EBIT + Depreciation + Amortisation

Example:

EBITDA Calculation Table
 

EBITDA and Company Valuation

EBITDA is commonly used in valuation metrics like EV/EBITDA, which compares enterprise value to EBITDA. This is used in:

• Mergers and acquisitions
• Private equity investments
• Peer analysis

Example: Let’s see the calculation of ABC company.
 

Importance of EBITDA for Investors

Investors use EBITDA to:

• Understand a company’s core performance
• Compare across companies with different capital structures
• Identify potential investment opportunities

Why Investors Like It:

• Removes the impact of interest and taxes
• Easier to compare domestic and international firms

Example: One day Rajat was comparing two companies: Company X and Company Y, to understand who had a better operational efficiency. Below is the table which gave him a clear picture:

EBITDA Margin Comparison
 

This comparison helped Rajat see which company managed its operations more efficiently.

EBITDA Margin

The EBITDA margin tells how much EBITDA a company earns as a percentage of its total revenue: EBITDA Margin = (EBITDA / Total Revenue) × 100. Higher EBITDA margins reflect strong control over operational expenses.

Example: Let’s understand it through an example through ABC company refer to the table given below:
 

The table reveals how even with increasing revenue, EBITDA margin can indicate expense control.

EBITDA vs Other Profit Metrics

While EBITDA is a popular indicator of profitability, it is not the only number investors consider.  Priya shared with Aman: "EBITDA gives you an idea of a company's core operational performance, but it doesn't tell the whole story." Different measures reflect different layers of profit depending on whatever costs are included or eliminated.

To illustrate the difference, consider the following comparison table, which shows how EBITDA differs from EBIT and Net Profit when interest, tax, and depreciation charges are included:
 

Example: Let’s see how Sneha used all three metrics: 

Profit Metrics Comparison
 

Limitations of EBITDA

While EBITDA is helpful, it has drawbacks:

• Ignores capital expenditure (capex) requirements: EBITDA excludes the actual cost of sustaining or growing fixed assets, which can have a major impact on long-term viability.
   
• Manipulation is possible, such as exaggerating revenue or under-reporting expenses. Companies may alter figures to present a better picture of their operations.
   
• Does not reflect actual cash flow: It eliminates working capital movements, loan repayments, and capital expenditures, all of which are critical to understanding genuine liquidity.

Example: Let’s understand it through an example on how EBITDA and actual cash Availability works please refer to the table given below:
 

Here, we can see how strong EBITDA doesn’t always mean good cash availability if expenses are high.

Conclusion

EBITDA is an effective measure for assessing a company's basic performance and comparing it across industries.  But, as Rajat and Sneha discovered, it should not be the only lens you use.  On its own, EBITDA overlooks important aspects such as capital expenses, financing costs, and actual earnings.

Consider EBITDA as a starting point, not the final word.  Combine it with variables such as cash flow, debt levels, and net profit to make more informed investment decisions.  A well-rounded study provides a more accurate view of a company's underlying financial health.

FAQs on EBITDA

How does EBITDA impact credit analysis?

Lenders frequently use EBITDA to evaluate a company's ability to repay loans because it indicates recurrent earnings available before interest payments.

Can EBITDA be used to evaluate startups?

EBITDA is less predictable for early-stage firms, which frequently have irregular revenues and hefty upfront costs, making other metrics such as cash burn more important.

Why do some analysts prefer EBIT to EBITDA?

Some prefer EBIT because it includes depreciation and amortisation, which are critical for asset-heavy organisations because equipment deterioration affects profitability.

How does EBITDA differ between service and manufacturing companies?

Service organisations frequently have greater EBITDA margins due to fewer fixed expenses, but manufacturing businesses incur significant depreciation and capex that EBITDA ignores.

What is the effect of seasonality on EBITDA?

For seasonal firms, quarterly EBITDA can be quite volatile.  Analysts use year-over-year or trailing 12-month EBITDA to level out seasonal influences.

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