Small Business Private Equity
By: Paul Wormley
EBITDA is a term that people use all the time but it can’t be found on a financial statement. So what is it?
EBITDA = Earnings (net income) + Interest + Taxes + Depreciation + Amortization. It’s a shorthand way to determine how much cash a company generates in comparison to other companies.
Interest – The amount of interest a company pays is dependent on how much debt it has. If a business has a lot of debt it will have a lot of interest expense. The identical business without any debt will have zero interest expense. Because the debt structure of a company is not related to how much cash its operations generate (only where that cash goes) interest is added back in EBITDA.
Taxes – Much like debt, the amount of income tax expense a company pays is highly dependent upon such things as corporate form (S Corp v. C Corp), accounting practices, the amount of debt it has, and other factors not related to its operating performance. This is why it too is added back in EBITDA.
Depreciation & Amortization – Depreciation and amortization are non-cash charges against earnings. Depreciation reflects the declining value of a tangible asset (like a piece of equipment) as it wears out or becomes obsolete. Amortization reflects the declining value of an intangible asset (like a patent) as its useful life declines. The accounting treatment of depreciation and amortization rarely reflect the real “costs” associated with acquiring/owning these assets and, since they are non-cash charges, adding back depreciation and amortization better reflects current-period cash flows.
There is one important caveat related to Depreciation and tangible assets: Buying tangible assets (like equipment) is a real cash costs (typically referred to as capital expenditures or ‘capex’). Capex shows up on the balance sheet (in the form of additional fixed assets) instead of the income statement (as an expense). So we often refer to a company’s ‘EBITDA less capex’ instead of just its EBITDA.