What’s EBITDA?

E-BUH-What?

EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation and Amortization.

It’s pronounced E-BIT-DA.

Why do I need to know about EBITDA?

Investors and lenders love it! So if you want money from investors or banks, then you have to learn about this financial metric.

Ok, so what’s the formula?

Why all the love?

Investors feel that EBITDA gives them the cleanest view of how the business model of a company is actually working. It’s all about the earnings generated from sales.

EBITDA tells investors how much cash a business generates from its sales before paying the tax man, interest on loans, and required upkeep for things like equipment. This metric lets investors easily compare companies, regardless of service, product, or industry, which is why it’s the standard for valuing businesses.

Note: Investor rationale for ignoring taxes, interest, and depreciation & amortization when evaluating company performance is grounded in the belief that these costs are biased by management choices, subjective judgments, and outside influences. Specifically, tax rates are dependent upon prior years’ losses, acquisitions, and changes in the tax code. Interest expense is largely a function of management’s choice of financing. Depreciation & Amortization includes judgments around useful lives, residual values, and depreciation methods.

What’s the catch?

It’s not recognized by U.S. GAAP. That means there is no legal requirement for companies to disclose EBITDA. You won’t find an EBITDA field on the annual reports of companies like Google, Apple, or Wal-Mart.

And while EBITDA is a proxy for cash, it’s not a substitute for cash flow. For starters, tax and interest are real cash items. Neither Uncle Sam nor the bank consider them optional cash payments. Therefore, if you’d like to stay in business, then from EBITDA you will have to deduct payments for taxes and interest.

While technically considered a non-cash charge for accounting purposes, the costs of depreciation and amortization are real. As a refresher, depreciation and amortization is a real expense because the cash outlay it represents is paid up front, before the asset purchased (e.g., equipment or website) has delivered any benefits to the business.

That’s why CEOs and CFOs don’t use EBITDA to drive performance in their company.

Remember, it’s just one metric

EBITDA is simply one metric on which to evaluate a business. It will never provide a complete picture of a company’s performance. Use EBITDA in conjunction with other, more meaningful metrics (e.g., revenue growth, user growth, gross margin) to better understand your business and drive its performance.

Originally published at facingthenumbers.com on June 29, 2016.