EBITDA: the profit number to use with care

The lesson in plain words

The same lesson as the slides above, written out in full.

1. What EBITDA really means

Welcome. EBITDA is one of the most quoted numbers in finance, and also one of the most argued about. Over the next few minutes we will unpack what each letter means, why some people reach for it, and why others treat it with real caution. By the end you will be able to read an EBITDA figure and know the right questions to ask.

• EBITDA stands for earnings before interest, tax, depreciation and amortisation
• It is a measure of operating profit before financing and accounting choices
• Think of it as a company's earnings with several items stripped out
• It is quoted often in reports and headlines, and also widely criticised
• This lesson covers both the useful side and the caution side

A quick note: This is financial education only, not financial advice. The figures used here are illustrative and chosen to make the idea clear, not to describe any real company.

2. What EBITDA strips out

To see what EBITDA is, start at the bottom with net income and work back up. You add back the interest a company pays on its debt, the tax it owes, and the depreciation and amortisation charges that spread the cost of past investments over time. Strip those four things out and what remains is EBITDA. The goal is to get closer to the profit the core business generates before financing and accounting choices.

• Start with net income, the bottom-line profit after everything
• Add back interest, the cost of the company's borrowing
• Add back taxes, which depend on where and how a firm is structured
• Add back depreciation and amortisation, non-cash accounting charges
• The result is EBITDA, earnings before those four items

3. Why some find it useful

Here is why some people like it. Imagine two companies running an almost identical business. One carries a lot of debt and pays heavy interest, the other does not, so their net income looks very different. EBITDA strips out interest and tax, so the operating engines can be compared more fairly. That is the appeal: a cleaner view of how the core business performs.

• Two firms can run the same business yet report very different net income
• The gap often comes from debt levels and tax situations, not operations
• By removing those, EBITDA aims to show core operating performance
• This makes it a common tool for comparing companies or different years
• It is also used to get a rough sense of cash generation

4. Where EBITDA can mislead

Now the caution. EBITDA leaves out interest, tax, and the wearing down of assets, but every one of those is a real cost. A famous investor once asked, only half joking, whether managers think the tooth fairy pays for capital spending. Depreciation reflects money already spent on equipment that will eventually need replacing, so a shiny EBITDA number can hide a business that is not really generating the cash it appears to.

• EBITDA ignores interest, yet debt is a real bill that must be paid
• It ignores tax, which is also real cash leaving the business
• Its biggest flaw: it treats depreciation as if assets never wear out
• Machines and equipment eventually need replacing, and that costs real money
• A high EBITDA can flatter a business that is quietly burning cash