Earnings Before Interest, Taxes, Depreciation, and Amortization, or EBITDA, is one indicator of a company’s financial performance, and is often used to calculate the earnings potential of a business.
Earnings are measured in terms of the approximate cash flow of the business to the owner(s) before income taxes and interest expense. Eliminating the tax effects and cost of debt allows prospective buyers to compare alternative investments and disregard the current financing structure of the business. In addition to income taxes and interest expense, depreciation and amortization have no immediate impact on the cash flow of the business, and therefore, must be included in earnings. As such, the formula for EBITDA is:
EBITDA = Net Profit + Interest Expense + Income Taxes + Depreciation + Amortization
Although Charlie Munger, Warren Buffet’s longtime business partner, stated that, “every time you see the word EBITDA, you should substitute the word ‘BS Earnings,'” EBITDA continues to experience widespread use. An experienced M&A Team understands the shortcomings of EBITDA and will be able to assist buyers and sellers in their decision-making process.