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<p>Financial statements involve a lot of terminologies that are important both for the concerned businesses and their stakeholders. Everything seems pretty boring until you see money in the bank.</p> <p>When it comes to earnings, there are multiple ways of presenting earnings. This includes earnings before and after tax, those after amortisation etc. One such terminology or way to represent a part of earnings is EBITDA.</p> <p>What is EBITDA? How is it used by the industry stalwarts and stakeholders for their analysis? Let’s decode one of the most important financial metrics—EBITDA. (Not as complicated as it sounds.)</p> <h2>EBITDA Meaning?</h2> <p><strong>EBITDA, full form</strong>, ‘Earnings Before Interest Tax Depreciation and Amortisation, is a metric to determine the company's operating income. The adjustments are made to reach a number that represents the income generated by a company solely from its core business activity. As the name suggests, it is the earnings before adjusting the following components:</p> <p><strong>1. Interest:</strong> Interest is not directly related to the company's operations as it is a financing cost incurred to raise capital for the company. Interest is payable by the company on various loans and advances that it takes from external sources.<br /> <strong>2. Tax:</strong> This represents the corporate or <a href="https://insider.finology.in/tax/how-to-save-income-tax-in-india" target="_blank" title="How to save Income Tax in India">income tax</a> the company pays to the government. It varies under the jurisdictions where the company operates and is not based on the company's management or performance.<br /> <strong>3. Depreciation:</strong> <a href="https://insider.finology.in/finance/written-down-value-method-of-depreciation" target="_blank" title="Written Down Value Method of Depreciation">Depreciation</a> on the tangible assets of the company. These non-cash expenditures are added back to the net income while calculating EBITDA.<br /> <strong>4. Amortisation:</strong> This usually denotes the devaluation of the company's intangible assets. Amortisation is similar to depreciation, a non-cash expense, and added back while calculating the EBITDA. (Intangible assets example - lease, EMI)</p> <p>EBITDA has significant relevance in financial statements as it is the crucial indicator of earnings from the company's operations.</p> <h3>How to Calculate EBITDA?</h3> <p>While we understand EBITDA's meaning, let’s see how to calculate EBITDA. EBITDA Ratio can be easily calculated from the income statement of the company.</p> <p>Following are the EBITDA formulas:<br /> <strong>EBITDA = Net income + interest + taxes + depreciation + amortisation</strong><br /> Or<br /> <strong>EBITDA = Operating profit + depreciation + amortisation</strong></p> <p>Here, net income is the company's income after considering all expenditures; therefore, interest, taxes, depreciation and amortisation are added to determine EBITDA.</p> <p>Operating profit considers only the operating income and expenses of the company. As the interest cost is not deducted from the income while calculating operating profit, it is not added back. However, as depreciation and amortisation are deducted from income while calculating operating profit, they are added back.</p> <h3>What is the EBITDA Margin?</h3> <p>The <strong>EBITDA margin</strong> is the ratio of the company’s operating profits to the revenue of the company. Following is the formula for calculating the EBITDA margin:</p> <p><strong>EBITDA Margin = EBITDA / Revenue * 100</strong></p> <p>It denotes the EBITDA as a percentage of the company’s revenue. The EBITDA margin is critical for comparing the company's operating income with its peers and the industry.</p> <h3>What is a Good EBITDA?</h3> <p>EBITDA is an absolute measure of the operating income of the company. Therefore, the higher the EBITDA, the better the company's position. However, it is essential to calculate its EBITDA margin to determine the company's health and whether it is performing per the industry’s benchmarks and standards. An ideal EBITDA margin is 10% or higher. For instance, if a company has booked revenue of ₹530 crores, then a 10% EBITDA Ratio implies that the company should have earned an EBITDA of at least ₹53 crores.</p> <p>The higher the EBITDA margin, the higher the company's operating profitability. In any case, the EBITDA should cover the interest, taxes, depreciation and amortisation expenses and leave enough earnings for distribution to the company's shareholders.</p> <h3>Example of EBITDA</h3> <p>Let’s understand how we can calculate EBITDA with a simple example:<br /> <strong>Example-1</strong><br /> Suppose Company ABC is engaged in the manufacturing sector. As of 31st March 2022, its income statement reflected the following figures:</p> <table border="1" cellpadding="1" cellspacing="1" style="width:500px" summary="Let’s understand how we can calculate EBITDA with a simple example: Example-1 Suppose Company ABC is engaged in the manufacturing sector. As of 31st March 2022, its income statement reflected the following figures:"> <caption>Example of EBITDA</caption> <tbody> <tr> <td>Net Income</td> <td>₹12,40,000</td> </tr> <tr> <td>Interest Expense</td> <td>₹1,23,000</td> </tr> <tr> <td>Income Tax</td> <td>₹94,500</td> </tr> <tr> <td>Depreciation</td> <td>₹3,44,000</td> </tr> <tr> <td>Amortisation</td> <td>₹1,74,000</td> </tr> </tbody> </table> <p>It wants to know its EBITDA to determine its operational efficiency and profitability.</p> <p>EBITDA = Net income + interest + taxes + depreciation + amortization<br /> = ₹12,40,000 + ₹1,23,000 + ₹94,500 + ₹3,44,000 + ₹1,74,000<br /> = ₹19,75,500.</p> <p><strong>Example-2</strong><br /> Suppose Company XYZ, engaged in retail trading, wants to calculate its EBITDA for the FY ending on 31st March 2022. It has presented the following figures:</p> <table border="1" cellpadding="1" cellspacing="1" style="width:500px" summary="Suppose Company XYZ, engaged in retail trading, wants to calculate its EBITDA for the FY ending on 31st March 2022. It has presented the following figures:"> <caption>Example-2</caption> <tbody> <tr> <td>Operating Income</td> <td>₹9,64,000</td> </tr> <tr> <td>Interest Expense</td> <td>₹1,12,000</td> </tr> <tr> <td>Income Tax</td> <td>₹1,12,000</td> </tr> <tr> <td>Depreciation</td> <td>₹2,57,000</td> </tr> <tr> <td>Amortisation</td> <td>₹1,28,900</td> </tr> </tbody> </table> <p>Here, for calculating EBITDA, we will use the following formula:</p> <p>EBITDA = Operating profit + depreciation + amortization<br /> = ₹9,64,000 + ₹2,57,000 + ₹1,28,900<br /> = ₹13,49,900</p> <p><strong>Analysis:</strong> In the first example, Company ABC provided net income. It implies that the interest, taxes, depreciation and amortisation were already deducted from the company's profits to arrive at the net income. Therefore, all four components were added to the net income to calculate EBITDA.</p> <p>However, in the second example, operating income was provided by Company XYZ. It implies that only the operating items were considered for calculating the active income, which includes depreciation and amortisation. As the interest and taxes are not considered while calculating operating income, they are not added back for calculating EBITDA.</p> <p><strong>Example-3</strong></p> <p>Company PQR deals in automobiles and clocked a revenue of ₹1.50 crores and earned an EBITDA of ₹20 lakhs for the year ending on 31st March 2022. However, one of its competitors, Company MNQ, booked revenue of ₹2.1 crores with an EBITDA of ₹22 lakhs. Company PQR feels that it lags behind Company MNQ because of operational inefficiency.</p> <p>The automobile industry has an EBITDA margin of 12%, which is the benchmark rate for all the players in the industry. Company PQR wants to track its performance against the industry standards and Company MNQ.</p> <p>In such a case, the Company PQR should calculate its EBITDA margin to determine whether it can generate sufficient profits from its operations.</p> <p><strong>EBITDA Margin = Operating profit / Revenue * 100</strong></p> <p>Therefore, the EBITDA margin for Company PQR and Company MNQ shall be as follows:<br /> Company PQR = ₹20 lakhs / ₹1.50 crores * 100 = 13.33%<br /> Company MNQ = ₹22 lakhs / ₹2.10 crores * 100 = 10.47%</p> <p><strong>Analysis:</strong> While Company MNQ has a higher turnover and profitability, it is not operationally efficient compared to Company PQR and the industry. This is because its EBITDA margin is just 10.47% compared to the industry benchmark of 12%. Therefore, it needs to improve its operational efficiency.</p> <p>In the case of Company PQR, operationally, it is very efficient as its EBITDA margin of 13.33% is higher than the industry average of 12%. Therefore, it should focus on customer acquisition and increasing its sales to overtake Company MNQ.</p> <p>This is how an EBITDA margin can help businesses make the right decision. While Company PQR thought that it was operationally inefficient, which resulted in lower profits, all it had to do was to focus on increasing its sales. Had Company PQR not calculated the EBITDA margin and just relied on the absolute figures, it would have focused on improving its operational efficiency, which is already efficient. In this way, it wouldn’t have been able to make informed decisions to overtake Company MNQ.</p> <h3>Amortization meaning in EBITDA</h3> <p>Depreciation and amortisation are two crucial components in calculating EBITDA Ratio. To understand amortisation, it is important to understand depreciation.</p> <p>Businesses often invest in the company's fixed assets, such as plants and machinery, furniture, etc. However, these are the company's capital expenditures and lead to the creation of assets for the company. Therefore, they form part of the balance sheet.</p> <p>However, these fixed assets are used for the company's operations; consequently, recording their changeability against the company's profits is essential. This is done through depreciation.</p> <p>As the assets are used, their value reduces due to wear and tear over time. This reduction in value is known as depreciation. The depreciation amount is reduced from the gross value of assets and transferred to the debit side of the company's income statement.</p> <p>The concept of amortisation is similar to depreciation. However, while depreciation is for the company's tangible assets, like plant and machinery, vehicles, furniture, etc, amortisation is for the company's intangible assets, such as patents, software, goodwill, etc.</p> <p>The value of an intangible asset does not reduce due to wear and tear; however, the law has assigned a specific use life to the intangible assets that should be amortised. This amortisation expense is transferred to the debit side of the income statement, just like the depreciation expense.</p> <h3>How is EBITDA Used?</h3> <p>As stated earlier, EBITDA is essential to the company's operating income. It is widely used in the industry by various stakeholders to determine the performance and financial health of the company. Following are the uses of EBITDA, making it one of the most important financial metrics:</p> <p>It is used for tracking the company's performance and profitability</p> <ol> <li>EBITDA is used to determine if the company is generating enough profits from its operations</li> <li>EBITDA is a key component for determining the enterprise or business valuation</li> <li>EBITDA is used for calculating different ratios like Net Debt to EBITDA ratio, Enterprise Value to its EBITDA ratio, Debt Service Coverage Ratio (DSCR), etc.</li> <li>EBITDA is widely used in asset-intensive industries that involve a lot of plants and equipment. This is because these industries charge a considerable depreciation, obscuring profitability. EBITDA helps determine the actual operating profits in such industries as it excludes depreciation expenses for determining the company's profits</li> <li>IT companies spend a significant amount on software development and other intellectual properties, encompassing huge amortisation expenses. Therefore, early-stage research and IT companies use EBITDA to determine their performance and profitability.</li> </ol> <h3>Pros and Cons of EBITDA</h3> <p>Each financial metric has its benefits and shortcomings. When it comes to EBITDA, the following are the pros and cons that stakeholders should be aware of while using it for decision-making and necessary calculations:</p> <p><strong>Pros of EBITDA</strong></p> <ol> <li>It provides a better result for the business's health and profitability.</li> <li>It eliminates capital investment and financing expenses that help determine the company’s baseline profitability without any expenditures to acquire assets or expenses for raising capital factoring into the assessment.</li> <li>It shows the actual operating expenses and income associated with the business and thus helps in determining how well the business model is working.</li> <li>It serves as a metric to compare the operational efficiency among peers and industry benchmarks, helping identify the scope of improvement.</li> </ol> <p><strong>Cons of EBITDA</strong></p> <ol> <li>EBITDA ignores the changes in working capital. Profits are affected due to interest costs, taxes and capital expenditures.</li> <li>Taxes are an essential business component, and EBITDA ignores the same.</li> <li>Suppose the organisation is over-leveraged or has a considerable debt burden. In that case, even though it is generating profits through operations, it might be in loss due to substantial interest costs. EBITDA does not show the financial burden of the business.</li> <li>It does not show the company's liquidity, as the cash might just be tied to the stocks or debtors of the company. However, the interest and taxes need to be paid in cash.</li> <li>EBITDA might not help secure loans and financing as loans are provided based on the actual financial performance of your business.</li> </ol> <h3>What is Adjusted EBITDA?</h3> <p>It is usual for any business to have non-recurring events. This can distort EBITDA, and the final EBITDA figure may not truly represent the trend and performance of the company.</p> <p>Therefore, removing the effects of these one-time, irregular and non-recurring items from EBITDA is essential. These items are adjusted in the EBITDA calculated to derive Adjusted EBITDA.</p> <p>Following is the formula for Adjusted EBITDA:<br /> <strong>Adjusted EBITDA = EBITDA +/(-) Adjustments for one-time, irregular and non-recurring items.</strong></p> <p>Some of the examples of items that need to be adjusted in EBITDA include:</p> <ol> <li>Unrealised gains or losses</li> <li>Non-operating income</li> <li>One-time gains or losses</li> <li>Non-cash expenses</li> <li>Special donations</li> <li>Litigation expenses</li> <li>Forex gains or losses</li> <li>Impairment of goodwill, etc.</li> </ol> <h3>Frequently Asked Questions</h3> <p><strong>Q: Should interest on unsecured loans be added to net income while calculating EBITDA?</strong><br /> A: Yes. Unsecured loans also form part of the financing, so they should be treated at par with secured loans. Thus, interest on unsecured loans should be added to the net income in the same way as interest on secured loans.</p> <p><strong>Q: Does GST have any implication in the calculation of EBITDA?</strong><br /> A: No. GST has no direct implication in the calculation of EBITDA. It is not a tax paid on profitability to the government. It is collected from the customers and does not form part of turnover or profitability. Therefore, it should not be added back to net income while calculating EBITDA.</p> <p><strong>Q: How is EBITDA different from EBIT, EBT, and EAT?</strong><br /> A: The following are the significant differences between all four financial metrics:</p> <ol> <li>EBITDA: It is 'Earnings Before Interest Tax Depreciation and Amortisation'. It indicates the operational profitability of the company.</li> <li>EBIT: It is 'Earnings Before Interest and Tax'. It accurately indicates operational profitability as it also considers depreciation and amortisation.</li> <li>EBT: It is 'Earnings Before Tax'. It shows the final profits of the company before deducting taxes. Apart from operational gains, it also considers financial costs as interest expenses.</li> <li>EAT: It is 'Earnings After Tax'. It is the final profit that the company has earned after meeting all of its expenditures. These are the earnings available for distribution to the owners of the company, i.e., the shareholders.</li> </ol> <p>Each of the above financial metrics has its significance and importance and is used by the stakeholders and industry experts for their analysis and evaluation.</p> <p><strong>Q: Is EBITDA equivalent to the operating cashflows of the business?</strong><br /> A: No. EBITDA is not equivalent to the operational cashflows of the business. Operating cashflows determine the actual cashflows through operating activities. EBITDA, on the other hand, determines only the profitability through operations. These profits may or may not have been realised by the business. This is because EBITDA does not consider liquidity and working capital in its calculation. While the sales generate operating profits, most of the money might still be stuck in the debtors. This will lead to a higher EBITDA but a lower operating cash flow for the business.</p> <p><strong>Q: What are the ways to increase EBITDA for our business?</strong><br /> A: If you want to increase EBITDA for your business, then you need to focus on growing your sales. Further, to improve operational efficiency, you should reduce unnecessary operating costs. Such costs directly chew up your operating profits. Reducing unnecessary expenses will also help increase your business's EBITDA margin, indicating better operational efficiency.</p> <p><strong>Q: What are the downsides of a very high EBITDA margin?</strong><br /> A: A very high EBITDA margin might seem reasonable at first. Still, the business should ensure that the quality of the goods or services is not compromised in pursuing a higher EBITDA margin. The company might use sub-standard and low-quality materials to decrease costs to attain a higher EBITDA margin. In the long run, this can become a business nightmare.</p> <h4>The Bottom Line</h4> <p>EBITDA is a significant financial metric for assessing the operating profitability of a business. It has its pros and cons, like any other metric. However, it is still widely used by all categories of stakeholders.</p> <p>However, when determining true profitability and whether a business can meet its obligations, it is important to consider financial costs, which EBITDA fails to do. This is why we can and should consider other metrics like EBT, EAT etc. </p> <p>EBITDA Ratio is just one of the ways to understand a company’s operations and profitability. To conduct a better fundamental analysis of companies, check out Quest’s course on the <a href="https://quest.finology.in/app/course/financial-statement-analysis" target="_blank">Analysis of Financial Statements</a>.</p>
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