What Is EBITDA?

If you’ve read or listened to the earnings reports of companies you follow, you’ve probably heard the term “EBITDA.” But what exactly does it mean, and why is it important? Why do some companies talk about it, but others don’t? And how can understanding it make you a smarter investor?

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Here’s what you need to know about EBITDA.

What Is EBITDA?

EBITDA stands for earnings before interest, taxes, depreciation and amortization. In simple terms, it’s a way to measure profitability. Net income, which is earnings after all the charges that EBITDA ignores are considered, is also a measure of profitability, but EBITDA is used to estimate a company’s potential profitability.

To break it down, EBITDA consists of:

Earnings: This represents the amount of money the company brought in after paying its expenses, such as materials, labor costs, etc. In the case of EBITDA, however, some expenses are excluded, or added back in. Thus, the “B” in EBITDA stands for “before” these costs:

Interest: This is the cost the company pays to borrow money to fund its operations. A company may have bank loans or lines of credit on which it pays interest. EBITDA does not subtract interest from earnings, thereby leveling the playing field for companies with different capital structures.

Taxes: Taxes can vary by business structure and location, so removing taxes from the equation removes these differences.

Depreciation: Depreciation is the monetary value of the deterioration of fixed assets over time. Manufacturing companies often have large depreciation expenses since they have equipment that declines in value the longer it is used. By removing depreciation from the equation, EBITDA removes the variation in this cost that can come from the age of the equipment.

Amortization: Amortization is similar to depreciation but applies to intangible assets, like intellectual property.

A note on depreciation and amortization: These are not outlays of cash, but they do reduce the value of an asset. For example, if you have purchased a piece of equipment for $100,000, it may be worth $90,000 in a year. Therefore, the depreciation cost for that piece of equipment for that year is $10,000.

Likewise, a patent that is valued at $250,000 when it is first issued may be considered to be worth just $200,000 a few years later because it is that much closer to the end of its useful life. The company that owns the patent hasn’t spent that $50,000, but it has an asset that is valued at $50,000 less than it had been. This decrease in value is represented by amortization.

How Is EBITDA Used To Measure a Company’s Fiscal Health?

EBITDA is a way to express a company’s profitability, factoring out some costs related to financing, tax strategy and the duration of assets. Companies will often report EBITDA if net income paints a less-than-rosy picture of the company’s financials.

The difference between EBITDA and net income is that net income factors in the items that EBITDA factors out (i.e., interest, taxes, depreciation and amortization). Net income is used to calculate earnings per share and compares a company’s performance over time, or its performance relative to expectations.

EBITDA is not a GAAP (generally accepted accounting principle) measure, so when companies report earnings, they will also report other metrics like net income. Companies are not allowed to report EBITDA per share. According to the Securities and Exchange Commission, they can only report earnings per share. EBITDA is often used in mergers and acquisitions or when comparing one company to another.

Why EBITDA Is Important

EBITDA reflects a company’s profitability, but it also reflects the company’s potential for profitability. This may seem like a minor distinction, but it’s important when one company is planning to acquire or merge with another company.

Because it factors out depreciation and amortization, EBITDA is often used by companies that have a lot of expensive assets, like manufacturing facilities or equipment, or those that have patents or other intellectual property. For these kinds of companies, depreciation or amortization expenses can camouflage, in a way, the companies’ profitability.

How To Calculate EBITDA

Here is an example.

Company A has $10,000,000 in revenue. It has $3,000,000 in cost of goods sold and labor costs and $1,000,000 in other operating expenses. It paid $500,000 in interest and $1,500,000 in taxes, and it has $1,000,000 in depreciation.

Company A’s net income is $6,000,000 ($10,000,000 in revenue minus $4,000,000 in cost of goods sold and labor plus other operating expenses). Its EBITDA is $9,000,000.

Company B also has $10,000,000 in revenue. It has $3,000,000 in cost of goods sold and labor costs and $1,000,000 in other operating expenses. It paid $1,500,000 in taxes and has amortization of $500,000. It has no interest expense and no depreciation. Like Company A, it has $6,000,000 in net income. It has $8,000,000 in EBITDA.

At first glance, it may seem as though Company A is the more valuable of the two companies. After all, it has EBITDA of $9,000,000 compared to Company B’s EBITDA of $8,000,000. But a closer look reveals a couple of things:

• Company A paid $500,000 in interest, whereas Company B paid none. This likely means that Company A has outstanding loans, and Company B does not.

• Company A had $1,000,000 of depreciation, whereas Company B had $500,000 of amortization. This indicates that Company A likely has relatively new equipment, whereas Company B may have more mature intellectual property.

When trying to compare two companies on an apples-to-apples basis, EBITDA can be helpful, but it’s important to look at the circumstances behind the numbers. This will provide a more accurate picture of the health of both companies.

What the Experts Say About EBITDA

The Securities and Exchange Commission has strict rules for reporting non-GAAP financial measures, of which EBITDA is one. One of these rules is that companies must report per-share results as calculated from earnings, not from EBITDA. Companies must also use GAAP standard financial statements, including balance sheet and cash flow statements.

Warren Buffett, widely considered to be the most successful investor ever, does not consider EBITDA to be a useful measure, simply because it excludes the costs associated with financing and accounting decisions. In a letter to Berkshire Hathaway shareholders, Buffett famously once said, “References to EBITDA make us shudder — does management think the tooth fairy pays for capital expenditures?”

The discussion around the utility of EBITDA often centers around depreciation and amortization. Since these are not actual outlays of capital, some analysts think they should be added back into the calculation when comparing companies. But others argue that depreciation and amortization result in a reduction in the firm’s assets and therefore should be represented.

EBITDA can be a useful tool, particularly for investors who may be trying to compare two companies. But it is just one tool to be considered since it doesn’t necessarily tell the whole story.

This article originally appeared on GOBankingRates.com: What Is EBITDA?