How is EBITDA calculated and what is it used for?

How is EBITDA calculated and what is it used for? EBITDA, an acronym for Earnings Before Interests Taxes Depreciation and Amortization, is a fundamental indicator for the valuation of companies and stocks. But what lies behind this acronym and why does it arouse so much interest among investors in quarterly accounts and analysts’ forecasts?

In the stock market, EBITDA is a common term, especially when the balance sheets or financial reports of listed companies are published. It is an indicator often used by analysts to make estimates and forecasts in relation to the target price of a stock.

EBITDA indicates the ability of a company to generate income exclusively through operating management, i.e. the activities connected to the core business of the company in question. Therefore, it is considered a valid indicator of profitability, although it has some limitations.

Let’s try to give a simple and clear definition of EBITDA, providing all the information for its calculation and to understand how it is used and how it differs from other indicators.

What is EBITDA: meaning and definition

EBITDA is one of the balance sheet analysis indices used to measure the operating performance of a company. It provides information on the profitability of a company excluding some non-operating expenses and accounting decisions.

But what is EBITDA in practice?

As the name suggests, EBITDA - an English acronym for Earnings Before Interests Taxes Depreciation and Amortization - indicates the operating profitability of a company, focusing exclusively on the activities related to the company’s core business.

Calculating EBITDA therefore allows you to measure:

• the company’s ability to generate positive cash flows;
• the resources available to the company to make new investments;
• the company’s ability to pay interest on debt;
• the remuneration of shareholders;
• the intrinsic value of the company compared to others in the same sector.

EBITDA calculation and formulas

There are two formulas for the EBITDA calculation. In fact, this indicator is not found in the balance sheet, but can be easily obtained from the value-added income statement. That is, it is necessary to reclassify the income statement in order to group the accounts according to a management logic.

The most common formula is the following (direct method):

EBITDA = Production value - Raw material costs - Service costs - Personnel costs - Operating costs

From this last formula, it is clear how EBITDA expresses the profitability of the company’s business by isolating it from the rest of the company’s management.

There is also an indirect method for calculating EBITDA. The formula involves starting from the net profit:

• Net profit +
• Taxes +
• Depreciation +
• Provisions +
• Write-downs -
• Capital gains +
• Capital losses +
• Financial charges -
• Financial income +
• Non-characteristic costs -
• Non-characteristic revenues.

Both formulas allow you to determine a company’s earnings without the impact of its financial structure and accounting practices, thus providing a clearer view of its operating efficiency.

The value of EBITDA is usually indicated in the company’s quarterly report or balance sheet. This means that it is not always necessary to calculate EBITDA.

Example of EBITDA calculation

A practical example will help you better understand the EBITDA calculation process.

Let’s consider a company with the following financial data, taken from the latest annual income statement:

• Total revenues: €1,000,000
• Raw material costs: €200,000
• Service costs: €100,000
• Personnel costs: €150,000
• Operating costs: €50,000
• Depreciation: €30,000
• Financial charges: €20,000
• Taxes: €100,000

Let’s now calculate the EBITDA using the two formulas described:

Direct method
EBITDA = Production value - Raw material costs - Service costs - Personnel costs - Operating costs = €1,000,000 - €200,000 - €100,000 - €150,000 - €50,000 = €500,000

Indirect method
EBITDA = Net profit + Taxes + Financial charges + Depreciation = €350,000 + €100,000 + €20,000 + €30,000 = €500,000

EBITDA and more: other useful indicators for evaluating a company

EBITDA is then often used to build indicators useful for evaluating a company, such as Debt/EBITDA or Enterprise Value/EBITDA.

The indicators built through the gross operating margin allow to compare the operating profitability with the debt or with the overall value of the company in order to indicate whether the company in question is capable of repaying debts (or if it has been overwhelmed by them) or of generating value over time.

The difference between EBITDA and MOL

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and MOL (Gross Operating Margin) are both widely used profitability indicators, but they have substantial differences.

MOL represents the gross result of the ordinary management of a company, calculated as revenues minus costs, still excluding financial charges, amortizations and taxes. Differently, in EBITDA the provisions are already included in the calculation.

This distinction reflects the fact that the provisions, even if they do not involve immediate monetary outflows, could impact future cash flows. As a result, EBITDA may be lower than GOP, providing a more conservative estimate of operating cash flow. This discrepancy is particularly relevant in debt sustainability analysis, where the Debt/EBITDA ratio plays a crucial role.

The difference between EBITDA and EBIT

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and EBIT (Earnings Before Interest, Taxes) are two indicators calculated from the reclassification of the income statement.

While EBITDA represents the operating result of ordinary management before the deduction of financial expenses and taxes, EBIT includes depreciation. In short, the difference is summarized in the formula EBITDA (GOP - Provisions) - Depreciation = EBIT.

Limits of EBITDA

EBITDA is not free from problems, however. The first criticism concerns the absence of an accounting-legal standard that regulates the composition of EBITDA in detail. The lack of a general regulation, in fact, can favor the distorted use of this indicator, for example by varying its composition over time to hide profitability deficiencies.

EBITDA, moreover, does not take into account the taxes and interests that have a substantial weight on corporate balance sheets. It is not uncommon to find situations in which a company has a high amount of EBITDA and that at the end of the accounting calculations it finds itself at a loss given a huge imbalance in passive interests.

Finally, a company can overestimate or underestimate the reserves to be allocated for guarantees or restructuring expenses or bad debts, thus giving a distorted view of profits. If the income is then inflated by asset sales or by masking investments, a false view of company management is created.

To summarize... EBITDA in 7 points

• What is EBITDA: EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a financial indicator used to evaluate the profitability of a company, excluding interest, taxes, amortization and provisions.
• Meaning and definition: represents the income generated by a company exclusively through operational management, providing an idea of its ability to generate operating cash flows.
• Acronym: EBITDA is the acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization.
• Calculation and formula: EBITDA is calculated by subtracting operating expenses from total revenues, excluding interest, taxes, depreciation and provisions.
• Use and applications: It is widely used by investors and financial analysts to evaluate a company’s profitability and ability to generate operating cash flows.
• Differences with EBITDA: Compared to Gross Operating Margin (GOM), EBITDA includes provisions in the calculation, offering a broader view of company profitability.
• Importance in financial analysis: EBITDA is essential for assessing the sustainability of company debt and for making informed investment decisions.

Original article published on Money.it Italy. Original title: Come si calcola l’EBITDA e a cosa serve