How to use the Understanding EBITDA
EBITDA helps you measure a company's raw operational profitability by stripping away the effects of financing (Interest), government accounting (Taxes), and asset aging (Depreciation & Amortization). It allows for an "apples-to-apples" comparison between companies in different countries or with different debt structures.
🎯 Valuation Multiples
Investors often engage in M&A using an "EV/EBITDA" multiple (e.g., 10x EBITDA) rather than P/E ratio, especially for capital-intensive industries.
🏦 Why Lenders Love It
Banks use EBITDA as a proxy for 'money available to pay debt interest'. A high EBITDA/Interest ratio (Interest Coverage Ratio) suggests the company is a safe bet for a loan. It is the primary metric for Debt Covenants.
⚠️ The Buffett Critique
Warren Buffett famously dislikes EBITDA because "depreciation is a real expense." He argues that ignoring the cost of replacing old machinery (CapEx) gives a misleadingly inflated view of profits.
The Formula
EBITDA vs Operating Cash Flow
While often used interchangeably, they are NOT the same. EBITDA ignores changes in Working Capital (Inventory, Accounts Receivable).
Example: A company sells $1M of widgets on credit. EBITDA increases by $1M immediately, but the company has collected $0 cash. If they can't collect the money, they might go bankrupt despite having high EBITDA.
When to Use EBITDA?
- EBITDA Margin: Divide EBITDA by Revenue to see operating efficiency percentage.
- Heavy Capital Investment: Companies with big machines (Telecom, Utilities) appear less profitable due to high depreciation. EBITDA adds this back to show cash generation potential.
- Debt Capacity: Banks use "Net Debt / EBITDA" to judge if a company can service its loans.
Adjusted EBITDA
- Owner's Salary: If the owner pays themselves $200k but a replacement manager costs $100k, add back $100k.
- One-time Legal Fees: Lawsuits or patent filings that won't recur.
- Personal Expenses: Company cars, travel, or meals that are not strictly business-critical.