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Earnings before interest, taxes, depreciation, and amortization ( EBITDA )
Written by Kenny Foo   
Saturday, 07 March 2009 11:24

Investment Formula Description

Earnings before interest, taxes, depreciation and amortization ( EBITDA ) is an investment formula to calculate corporations' profitability by excluding expenses for interest, taxes , depreciation,  and amortization.

Profit before interest, taxes, depreciation and amortization ( PBITDA ) is another name for earnings before interest, taxes, depreciation and amortization ( EBITDA ). Unlike earnings before interest and taxes ( EBIT ), earnings before interest, taxes, depreciation and amortization ( EBITDA ) excluded the expenses for depreciation and amortization. The reason to exclude depreciation and amortization is because both are actually accounting principles to have fixed assets depreciated and amortized but it is not the actual expenses that pay out from the company. Hence, earnings before interest, taxes, depreciation and amortization is also known as non-GAAP ( Generally Accepted Accounting Principle ) investment formula since it does not include depreciation and amortization as expenses. For corporations with low depreciation and amortization, the investors will use earnings before interest and taxes ( EBIT ) while for corporations with high depreciation and amortization, the investors will prefer earnings before interest, taxes, depreciation and amortization ( EBITDA ).

A common misconception from investors are earnings before interest, taxes, depreciation and amortization ( EBITDA ) represents cash flow. Earnings before interest, taxes, depreciation and amortization ( EBITDA ) is not cash flow in cash flow statement because actual payments that are paid out by the companies like taxes and interest are excluded too.

Earnings before interest, taxes, depreciation and amortization ( EBITDA ) is commonly used by creditors and shareholders. For creditors, it give better idea of corporations' profitability by excluding non-actual cash expenses like depreciation and amortization. At the same time, earning before interest, taxes, depreciation and amortization ( EBITDA ) does not included interest and taxes as if the corporations have 0% loan and exempted for taxes. Thus, some corporations like to use earnings before interest, taxes, depreciation and amortization ( EBITDA ) to show better profit in the financial report. It is important for investors to look on other investment formula in financial report to prevent misuse of earnings before interest, taxes, depreciation and amortization ( EBITDA ). For shareholders, they need to take note that depreciation of capital expenditure ( CAPEX ) over few years has pros and cons too. The earnings before interest, taxes, depreciation and amortization ( EBITDA ) will have better profit by excluding depreciation but at the same time, the capital expenditure ( CAPEX ) on the first year is not reflecting the exact payment paid by the company. This is caused by the difference between accrual accounting and cash basis accounting.

 

Investment Formula

Earnings before interest, taxes, depreciation and amortization ( EBITDA )  = Revenue - Expenses ( excluding interest, taxes, depreciation and amortization )

Earnings before interest, taxes, depreciation and amortization ( EBITDA ) = Earnings before interest and taxes ( EBIT ) + depreciation +  amortization

 

Investment Formula Example

Corporation XYZ has $120,000 revenue for this financial year and it paid $20,000 interest and $5,000 taxes. Based on accrual accounting, it needs to charge $15,000 for depreciation and $15,000 for amortization. Its total expenses for this financial year is $100,000. The earnings before interest, taxes, depreciation and amortization ( EBITDA ) calculation is as following.

Earnings before interest, taxes, depreciation and amortization ( EBITDA )  = Revenue - Expenses ( excluding interest, taxes, depreciation and amortization ) = 120,000 - ( 100,000 - 20,000 - 5,000 - 15,000 - 15,000 ) = 120,000 - 45,000 = $75,000. 

The earnings before interest, taxes, depreciation and amortization ( EBITDA ) for corporation XYZ is $75,000. As investors can see, earnings before interest, taxes, depreciation and amortization can show better profit in financial report. If only deduct total expenses from revenue, corporation XYZ only has $20,000 profit. 

 

Besides, the investors can obtain earnings before interest, taxes, depreciation and amortization ( EBITDA ) from earnings before interest and taxes ( EBIT ) by adding back the depreciation and amortization. Corporation XYZ' s EBIT is $45,000. The earnings before interest, taxes, depreciation and amortization ( EBITDA ) calculation is as following.

Earnings before interest, taxes, depreciation and amortization ( EBITDA ) = Earnings before interest and taxes ( EBIT ) + depreciation +  amortization = 45,000 + 15,000 +15,000 = $75,000

The outcome for earnings before interest, taxes, depreciation and amortization is still same with previous formula.

This example will show the distortion of income that can be prevent using earnings before interest, taxes, depreciation and amortization ( EBITDA ). Corporation XYZ spend $50,000 to upgrade its equipments in the office, which means $50,000 is its capital expenditure ( CAPEX ).  The equipments are expected to depreciate over 5 year. On the first year, corporation XYZ actually paid $50,000 but it is only recorded $10,000 as depreciation while for second year until the fifth year, corporation XYZ is not paying any money for capital expenditure ( CAPEX ), but the earnings will be deducted for $10,000 depreciation each year. Earnings before interest, taxes, depreciation and amortization ( EBITDA ) can prevent this kind of distortion on income.



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Last Updated ( Thursday, 12 March 2009 11:05 )
 
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