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Your money: Look beyond Ebitda to assess a company
P Saravanan
Ebitda tells how a business performs over a period of time.
However, it does not accurately measure a firm’s liquid assets and
revenue.
For investors, Ebitda (earnings before interest tax depreciation and amortisation) is one of the most widely used
metrics as it provides a clear view regarding the core operating performance of a firm instead of focusing on the
bottom line, i.e., net profit after tax. Further, it helps the investors to value firms by comparing their operating profit.
However, depending on this metric alone could overstate a firm’s true performance as it is not a proxy for cash flow
and thus lead to dubious valuation. Instead, investors could use the following allied metrics in addition to Ebitda.
Ebitda margin
A company’s Ebitda margin is defined as the percentage of calculated Ebitda in relation to its overall revenue. The
goal is to figure out how much a company makes in cash profit. When a company’s Ebitda margin is higher than other
companies, it means the company has more growth potential.
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Ebitda coverage ratio
The Ebitda coverage ratio is calculated as Ebitda divided by the sum of principal and interest payments. An outcome
of one or more indicates that the firm has a better chance of paying off its debt obligations. Ebitda coverage ratio is an
independent measure of a company’s performance because it does not compare companies.
Adjusted Ebitda
Adjusted Ebitda is arrived at by deducting the costs associated with one-time, irregular, and non-recurring expenses
like litigation expenditure, forex loss, ESOPs etc., that have no bearing on a firm’s day-to-day operations. Adjusted
EBITDA standardises a firm’s income and expenses (which varies across firms and industries). By normalising the
income, cash flows and eliminating the outliers, adjusted EBITDA makes it easier for the investor to assess
businesses’ performance irrespective of their differences.
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Drawbacks of Ebitda
The potential flop in the calculation of Ebitda is the exclusion of capital expenditure and its components. Another
shortcoming is that when taxes and interest are added back to earnings, Ebitda ignores the cost of debt. As a result,
Ebitda is prone to manipulation and allows companies to conceal problem areas in their financial statements by
ignoring expenditures. Thus, a company’s performance risks can be hidden.
To conclude, Ebitda could be used to determine how a business performs over a period of time. However, it does not
provide an accurate reflection of a company’s liquid assets and revenue.
P Saravanan is a professor of finance & accounting at IIM Tiruchirappalli. With inputs form A. Paul Williams,
research staff at IIM Tiruchirappalli
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