EBITDA. I’ve heard this term plenty of times over the years, and yet, I don’t know why it’s so important. Yes, I know EBITDA stands for “Earnings Before Interest, Tax, Depreciation, and Amortization”. However, of its importance, I know little of.
- Quick and dirty estimate for cash flows
- Interest and taxes are omitted in EBITDA as they can be heavily impacted by losses from previous years, debt financing (argued should not be used to measure the inherent value of a company), etc.
- Depreciation and amortization are non-cash items that can be heavily influenced by company decision-makers
- Can be used to measure against other companies’ EBITDA as a proxy for cash flows and across industry averages
However, there are many critics to EBITDA:
- Does not include working capital considerations (cash outlays for inventory, for example)
- Interest and taxes are cash outflows, and with their removal, may over-value a company. And because they’re not included, EBITDA is not a true measure of a company’s cash flows
- The omission of depreciation and amortization, though non-cash, fails to recognize useful lives of long-term assets and their eventual need to be replaced (think machinery which will eventually fail)
- Not Generally Accepted Accounting Principles mandated (non-GAAP). As such, companies provide EBITDA as wanted, and because Earnings, Interest, Tax, Depreciation, and Amortization can be calculated differently from company to company, EBITDA can be massaged to tell a rosier picture and not be an apples-to-apples comparison
Investors like to use EBITDA as part of their valuation calculations of startups (okay, companies in general); though, like any metric, EBITDA may provide insight in a singular way. To overcome its shortcomings, EBITDA should be used in conjunction with other relevant metrics and ratios.