Entelequi

Earnings before interest, tax, depreciation and amortisation is a key profit figure used in finance.

A simple approach to its calculation is to take operating profit (AKA profit before interest and tax, “PBIT”) and add-back the amounts deducted for depreciation and amortisation – these can usually be found in a company’s statutory accounts, in the notes section.

Why is it used?

Two main reasons:
i) it aids comparison
ii) it’s a good indicator of cash generation

Apples with apples

Firstly a word on “profit”: this is a nebulous accounting term that can be calculated in many different ways. It essentially shows what is left over once certain expenses are deducted from a company’s income. But how these expenses are calculated, and which ones are included, can be open to interpretation. This makes it difficult to assess how “profitable” a company is.

EBITDA excludes interest, tax, depreciation and amortisation – all of which depend on factors such as how the company is funded and the accounting treatments that have been used. Excluding them gives a measure of profit that is more reflective of underlying trading performance and is therefore more useful as a comparator between different companies, or for the same company over time.

Cash is king

Another reason why EBITDA is useful is that it is a proxy for cash generation. As indicated above, profit is an accounting measure that can show a different result for the same set of transactions; as such, profit and cash are very different.

Taking depreciation as an example, which can be thought of as a mechanism for economic ageing: if a company buys an asset (say a computer) that costs £1,000 and expects it to last for 5 years, each year £200 of depreciation will be deducted from the company’s profit. This does not mean £200 of cash leaves the business each year. However, the company may decide that the useful economic life of the computer is actually 10 years; in which case its profit will only be impacted by an annual depreciation charge of £100.

Profit serves an important purpose in the world of accounting, but ultimately cash is what matters: a company can be profitable but still go bust. Or as many high-profile tech companies demonstrate, a business can be continually loss-making (such as Twitter) but it must never run out of cash (which has been a recurring threat to Tesla).

In summary…

By excluding items on the P&L (profit & loss account) that do not translate directly to cash, EBITDA is a good indicator of the underlying trading performance of a business. It is therefore a useful link between profit and cash and is often used as the starting point to assess cash generation.