What Is EBITDA?
EBITDA stands for “Earnings Before Interest, Taxes, Depreciation, and Amortization” and is a type of profit metric used to measure a company’s financial performance.
How Is EBITDA Used by Businesses?
High EBITDA numbers can show investors that the company is performing well. However, it does not tell the whole story. It is crucial for companies to pay interest, taxes, and account for depreciation and amortization. These elements should be included in the overall picture of the company’s conditions. As a result, EBITDA is not an accurate metric of a company’s profitability. In some cases, it can be used to mask poor choices. A company can use it to avoid showing things like high-interest loans or aging equipment that would be costly to replace.
Pros and Cons of Using EBITDA
Pros of Using EBITDA Explained
In some respects, EBITDA is somewhat like the price-to-earnings (PE) ratio. The good thing about EBITDA is that, unlike the PE ratio, it is neutral to capital structure. It reduces the risk of factors influenced by capital investment and other financial variables. EBITDA shows how well ongoing operations are performing in generating cash flow. It also shows the value of that cash flow. It can indicate whether a company is an attractive option for high-capital investors. EBITDA can provide a big-picture view of growth that can illustrate how the business model works. When a company is purchased, the debt does not transfer to the buyer. As a result, the buyer is unconcerned about how the business is financed at the moment of sale. Buyers may be more interested in matters such as customers and cash flow from existing debt or the age of assets.
Cons of Using EBITDA Explained
EBITDA ignores the cost of debt by adding taxes and interest to profits. It can be used to hide poor choices and financial flaws. Using EBITDA may not allow you to secure a loan for your company. Loans are calculated based on the actual financial performance of the company. The timing of copyrights and patents expires over time. Machinery, tools, and other assets lose value and utility. EBITDA fails to consider or acknowledge these costs. EBITDA overlooks high-interest financial burdens or conceals them.
Other Metrics to Use Alongside EBITDA
EBITDA can be used as part of company valuation. To build a complete financial picture, however, you need more data. The payback period can help you measure the time it takes for the returns to cover the costs. Considering the payback periods for different investments can help show which is the more profitable option. Net Present Value: the actual cash flow occurring at different times. It can provide a more complete view of a company’s earnings and financial health. It takes into account the time value of money. Return on Investment Ratio: this is the ratio of net profits to the cost of the investment. Often referred to as the company’s return on investment (ROI). The higher a company’s returns, the greater the profit for the investor for each dollar spent. Internal Rate of Return: this metric is used to calculate the rate of return for an investor in a specific investment.
When considering investing in a company, you need to know more information beyond just EBITDA. All of these metrics can provide valuable data on the risk versus reward of a potential investment.
What EBITDA Means for You
High EBITDA returns can make a company appear to be a smart investment. However, you still need to know more details. If you are considering investing in a company, look at all financial metrics, not just EBITDA. EBITDA retains some value in seeing how the company performed year over year. However, it does not reflect the true value of a company’s liquid assets or actual income. If you only look at EBITDA, you may end up investing your money in a company with a lot of debt to repay, or a company that needs to spend a lot of money replacing aging equipment and other assets. Considering other metrics as well will help you make a smarter decision.
So
If you own a company, do not base all your plans on just one number. In many cases, EBITDA may not reflect the actual financial health of your company. Instead, make your financial moves based on the most complete picture you have.
Source: https://www.thebalancemoney.com/ebitda-and-company-financial-performance-357557
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