Why is EBITDA important?
EBITDA is a way to measure a company’s core profitability. Along with other earnings measurements, it can provide key information about a company’s operations.
Consider, for example, a mining company that requires the heavy use of property, plant, and equipment (PP&E). This company is likely to have high depreciation costs because the operation requires so much machinery.
In this case, the EBITDA calculation can more relevantly indicate the company’s underlying earning power. In fact, many industries rely on large quantities of PP&E, including oil and gas, paper and packaging, and commercial real estate.
EBITDA also adds amortization costs back in, which expenses intangible assets like patents, service contracts, software, licensing agreements, and copyrights.
A company may have particularly high amortization expenses if their core business is intellectual property. In such cases, EBITDA prevents these expenses from obscuring overall profitability.
Finally, EBITDA adds tax and interest expenses back in. This can be useful because these numbers indicate how the operation is financed, but are not directly relevant to the company’s ability to generate revenue through sales of their products or services.
Measuring earnings before interest and taxes can also be useful when comparing the operating efficiencies of companies within different tax jurisdictions.
Summary
EBITDA is an important measure of earnings because it accounts for costs that might distort the true picture of a company’s ability to generate profits from its core operations.
How is EBITDA calculated?
EBITDA can be calculated in two ways. With either method, you’ll need the company’s income statement and cash flow statement.
Importantly, know that these two EBITDA calculations can differ. This is because net income sometimes includes numbers not included in operating income. For example, a one-time expense or non-operating income like gains on investment are not part of operating income.
Below are the formulas for both methods.
EBITDA formula: the net income method
The first method, the net income calculation, uses the following formula:
EBITDA = net income + taxes + interest expense + depreciation and amortization
Here, taxes and interest are added to net income to determine the operating income, or the profit gained from core business operations. Net income, taxes, and interest expenses are located on the income statement.
Next, depreciation and amortization are added. These are usually found on the cash flow statement.
EBITDA formula: the operating income method
The second method, the operating income calculation, uses the following formula.
EBITDA = operating income + depreciation and amortization
This calculation is more concise because operating income is calculated before taxes and interest are removed. Operating income is the company’s profit after subtracting expenses associated with normal operating activities.
Next, depreciation and amortization are added back in from the statement of cash flow.
Summary
EBITDA can be calculated using either the net income method or the operating income method. In some cases, the formulas can generate two different EBITDA figures for the same company, as net income and operating income are calculated differently.
An example of an EBITDA calculation
Below is a sample calculation of the EBITDA for Target, using both formula methods. The financials you see here can be found on the company’s 10-K filing with the SEC.
The net income method
Target’s income statement:
Target’s cash flow statement:
Calculation (in USD millions):
Net earnings= $2,930M+ taxes= $746M+ interest= $461M+ depreciation and amortization= $2,474MEBITDA= $6,611M
The operating income method
Target’s income statement:
Target’s cash flow statement:
Calculation (in USD millions):
Operating income= $4,110M+ depreciation and amortization= $2,474MEBITDA= $6,584
In this calculation, you can see that the EBITDA differs slightly from what’s above. This is because net income includes “net other (income) / expenses.” This number represents the difference between the EBITDA figure in both calculations.
Summary
The example above shows how to calculate EBITDA with both the net income approach and the operating income approach, using Target’s 2018 income statement and cash flow statement.
