EBITDA play important role when it comes to gauging a company’s financial success. Even though it cannot be considered a potent parameter to measure company’s overall profitability, it is reliable indicator of business’s operating performance.
EBITDA Stands for Earning Before Interest, Taxes Depreciation and Amortization. It can be seen as a proxy for cash flow from the entire company’s operations.
EBITDA is an effective tool when used correctly and in conjunction with other accounting metrics. It can help business owners and associates make wise decisions about their company’s direction.
Prospective investors and buyers who want to know more about a company’s future profitability will find it helpful; this metric makes it easier to compare two or more companies in the same industry.
Example
Suppose you wanted to elevate two businesses. To keep this example easy to follow we will compare two Juice stands with similar revenues, equipment and property investments, taxes and cost of production. But they will have big differences in how much net income they generate due to difference in their capital structure.
Juice Stand A was funded entirely by equity. Juice stand B was primarily used debt to fund its operations. The only difference between them is how they choose to finance these assets -one with debt and one with equity.
Particulars | Juice A | Juice 2 |
Revenue |
10000 |
10000 |
Cost of Goods Sold |
2000 |
2000 |
Interest Expense (15000 @10%) |
0 |
1500 |
Depreciation of Juice Stand |
500 |
500 |
Income Before Tax |
7500 |
6000 |
Net Income After (30% Tax) |
5250 |
4200 |
EBITDA |
8000 |
8000 |
Because Stand B uses substantially more debt (15000 at 10% interest) to finance its operations. It is less profitable in terms of net income (Rs.4240/- in profit v/s Rs.5250/-). However, when compared on the basis of EBITDA, the Juice Stands are equal, each producing Rs.8000/- in EBITDA form Rs.10000/- in sales last year.
What’s the lesson here? By looking at EBITDA, we can determine the underlying profitability of a company’s operations, allowing for easier comparison to another business.
Then we can take those results and gain a deeper understanding of the impact of company’s capital structure, eg., debt and capital expenditures, as well as differences in taxes (particularly if the companies operate in different places) on the company’s actual profits and cash flows.
Doing all that can go a long way toward helping you decide if a company is worth investing in and what price it’s worth.
In the example above, Juice Stand A would be worth more to investors since it is able to turn more of its EBITDA into net income. Juice Stand B isn’t as profitable because of its debt expense, so investors should be compensated by paying a lower stock price.
EBITDA is useful in following business activities.
Investing: If you are planning to invest in a company then EBITDA can help you understand whether or not the company has strong growth potential, particularly when compared to other companies, so you can decide if joining the team is worthwhile.
Budgeting: Say you’re planning your company’s budget for the next year and want to know if you can absorb the cost of upgraded machinery. With the EBITDA, you’ll have a good sense of your company’s financial health and will know if it’s the right time to add the extra expense.
Forming an exit strategy: If you’re ready to sell your business and would like to put your company on the market, an EBITDA analysis can prove to buyers that it’s a smart purchase and help you set the correct asking price.