Looking for businesses to invest in is a challenging prospect. Even when you’re targeting a specific industry, there are so many differences. How much funding has the company accepted? Do they use GAAP or non-GAAP accounting principles? Are their different tax implications based on location or other factors? These questions barely scratch the surface.
How can you compare a company’s income statement to others when there are so many variables? Many analysts use a metric called EBITDA, which stands for “Earnings Before Interest, Taxes, Depreciation and Amortization.” What does that really mean? Take a look at the formula below:
EBITDA = Net Profit + Interest +Taxes + Depreciation + Amortization
EBITDA takes a business’s net income and adds back in major categories of expenses. The metric gained popularity during the 1980’s, when buyers wanted to understand the debt payments a company could sustain before purchasing it.
Today EBITDA is used by many to gain a view into the operating profitability of a company. Proponents believe that adding back in the non-operating costs levels the playing field when attempting to compare like businesses in a specific niche or industry. Detractors believe EBITDA is a false indicator, in that it can be manipulated to make a company look more financially attractive than it really is.
The use of EBITDA in financial decisions is a hotly-contested one. How do these differences manifest themselves in real situations? Here are a few examples:
EBITDA gives businesses the flexibility to remove variables they can’t control. A business trying to compete for investment capital may know that their tax rates are drastically different than competitors, or that expenses like startup costs or rent were particularly high in a given year. Adding those costs back in to EBITDA allows business to present a more favorable financial picture to investors.
But, flexibility for businesses can also mean less visibility for investors. EBITDA isn’t governed by GAAP accounting principles, so business owners have a lot of leeway in determining what to include or exclude in the calculation. Companies with expensive equipment and low net profits can inflate themselves using EBITDA, while possibly masking the need the increase their product price (or reduce equipment costs).
Given the controversy surrounding EBITDA, another metric has emerged that some argue presents a truer picture: operating cash flow. Operating cash flow is subject to GAAP accounting principles, so it provides a more consistent set of rules that businesses must follow. Operating cash flow focuses specifically on cash going in and out of a company for a given time period, including goods & services bought and sold and salaries paid to employees. Longer-term investment decisions – like purchasing equipment and acquiring funding – are not included.
Regardless of whether you use EBITDA or operating cash flow (or both), it is critical to make sure to look at a variety of metrics to get a broader view of a company’s financial health. Debt loads (and their associated payments), capital expenditures, and net income are just a few to add to your toolkit. Incorporating these additional metrics into your dashboard will help you make more informed decisions.
