What EBITDA Really Says About Your Company's Financials

March 15, 2012

While earnings before interest, taxes, depreciation and amortization (EBITDA) can tell the story of a company's financial performance, it's not another word for cash flow. EBITDA is a great tool for looking at how a company's profitability compares to its competitors and others in its industry because it takes financing and accounting decisions out of the equation.

Here's the formula for EBITDA:

EBITDA = revenue - earnings (excludes taxes, depreciation or amortization)

EBITDA doesn't have information about the company's cash earnings or free cash flow (FCF). It also doesn't show what the company needs for working capital and replacing expensive equipment.

Let's say a oilfield services company provides a service to repair oil and gas equipment. An investor wants to know how much money the company made. This is the EBITDA. When looking at this information, people don't consider the company's debts and assets. Investors review this data on a regular basis -- could be daily, weekly or monthly -- to see how the numbers change. They tell the investor how much this service is needed.

Another example. Ed gets a paycheck for $2,500. Ed isn't going spend the entire amount on the latest gadgets as soon as it's deposited. There are bills to pay (fixed expenses), such as mortgage, car payments, phone and electricity. He also needs to buy food.

That $2,500 is the EBITDA. This information won't tell you how much is left over after paying fixed expenses, supplies, debts and capital expenditures. It doesn't even state whether the company has enough cash to pay for all of this. We can see Ed gets $2,500, but it doesn't tell us whether he can pay all of his bills and have money left to buy a gadget or two.

EBITDA doesn't consider capital expenditures, a critical item that shows the value of the company. Capital expenditures involve buying anything related to equipment, property and buildings as well as buying fixed assets and preparing an asset for use.

Investors won't find it helpful in evaluating small companies that don't have substantial loans or operational cash flow. It's more useful to large companies with sizeable assets or debt financing.

With EBITDA, some accountants can make a company's earnings look better than they do. Furthermore, those that analyze stock price multiples instead of bottom-line earnings will think a company has less value than it does because this produces lower multiples.

For cash flow information, rely on a cash flow statement rather than the EBITDA. The EBITDA isn't important enough in the world of accounting that the generally accepted accounting principles (GAAP) to have a definition for it included.

What financial data do you rely on to learn a company's story? What does it reveal? How often do you refer to it / update it?