INVESTING TERMS
What is
CAPITAL
EBITDA — earnings before interest, taxes, depreciation, and amortization — is a measure of a company’s profitability. As the acronym suggests, EBITDA represents a company’s net earnings before subtracting expenses from interest payments, taxes, depreciation, and amortization. This accounting concept is a proxy for cash flow, or how much a company earns from operations and present assets.
Deeper definition
EBITDA is a somewhat controversial accounting measure that is used as a rough approximation of a company’s cash flow. EBITDA allows financial analysts and investors to broadly compare the profit potential of different companies.
EBITDA
example
This infographic was designed by Avalaunch Media
One argument against EBITDA as a performance indicator is that it does not account for changes in working capital, a key measure of a company’s liquidity. Working capital fluctuates due to the impact of interest, taxes, and capital expenditures.
EBITDA?
The measure erases the distortions that can creep into a company’s accounting statements from the effects of interest payments, tax impacts (and the political noise associated with taxes), the depreciation of assets, and different takeover histories by ignoring amortization of goodwill, leaving only total cash flow.
SHORT-TERM
CAPITAL GAINS
Profits made from selling assets owned for one year or less.
LONG-TERM
CAPITAL GAINS
Profits made from selling assets owned for more than one year.
Jeff bought a vacation home for $100,000 and used it as a rental property for five years before selling it for $150,000, giving him a capital gain of $50,000.
Since he owned the property for more than one year, he calculated his long-term capital gain based on his tax bracket.
Since his annual income placed him in the 15 percent tax bracket ($37,651 to $91,150 for a single person in 2016), he didn’t have to pay any taxes on the profit.
If Susan pays only the minimum payment of $20 per month, it will take her 11 months to pay off her balance.
EBITDA doesn’t need to be measured by the Securities and Exchange Commission’s accounting standards, the Generally Accepted Accounting Principles (GAAP), so it is not a required line item on a company’s financial statement. EBITDA has become much more common in recent years, although many firms list an adjusted EBITDA figure.
Two partners are looking to buy another portfolio company for their investment firm. One target, CraftCo, generated $100 million in revenue in the prior financial year, with $40 million of product expense and $20 million of operating expenditures. Amortization and depreciation expenditure amounted to $10 million, making for a net profit from operations of $30 million.
Before the proliferation of
inexpensive computer
technology, it had been very
difficult to create and price
complicated derivative contracts, but this problem was more or less solved by the 1990s, thanks also to the Black-Scholes equation. Mortgage-backed securities became very common investment products. Instead of using derivatives to effectively balance risk, institutional traders began buying them up as ways to create leverage and take on much more risk. When the U.S. housing market began to crumble in 2006 and 2007, MBS investments spread throughout the banking system began to rapidly lose value, precipitating the crisis.
EBITDA
NET EARNINGS
INTEREST PAYMENTS,
TAXES, depreciation, and amortization.
Businesses structure their capital differently from one another, so one company may have a high debt burden from acquisitions or equipment that another company doesn’t have. Different companies pursue a wide variety of tax strategies. Minimizing these factors aids in comparison. However, EBITDA is never meant as a way of looking at a company’s actual profitability or the quality of its earnings.
The measure can be calculated by taking a company’s net income and adding back interest expense, taxes, depreciation, and amortization. Alternatively, it can be calculated by taking a company’s operating profit — EBIT, or earnings before interest and taxes — and adding depreciation and amortization.
Susan opens a credit card with a $1,000 credit limit and an interest rate of 14.99.
She makes a purchase of $200.
Susan understands she will pay interest on the balance until she pays it off, but she decides to carry a revolving balance.
If Susan pays only the minimum payment of $20 per month, it will take her 11 months to pay off her balance.
CraftCo’s interest expense is $5 million, making $25 million in earnings before taxes. Assuming a tax rate of 20 percent, net income becomes $20 million after $5 million in tax expenditures. To arrive at EBITDA, the partners add operating profit to depreciation and amortization expenses ($30 million added to $10 million). CraftCo’s EBITDA of $40 million is higher than the other firm under consideration, so the partners enter negotiations to buy CraftCo.
$100 million
$40 million
$20 million
$10 million
Minus
REVENUE
EXPENSES
Equals
$30 million
NET PROFIT
