Don’t be Fooled by EBITDA

Earnings before Interest, Tax, Depreciation and Amortization or EBITDA has been a popular accounting measure that some companies include in their financial statements.

It is, in essence, the profit of the company but with interest, tax, depreciation and amortization expenses added back. It is calculated as follows:

EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortization

This accounting tool was first introduced in the 1980s because companies wanted to give a better idea to investors of their operating profit without the variables of tax and interest. This tool is also useful for companies with high depreciation and amortization expense that is, perhaps, not justified. Companies that have a large portfolio of properties, for example, prefer to add depreciation cost back into the calculation of profits as properties usually appreciate in value.

Downside of EBITDA

However, in recent years, many companies have been using this metric to spice up earnings instead. This phenomenon is apparent in companies operating in industries where using EBITDA as an accounting measure is not warranted.

For example, some healthcare companies may use EBITDA in their financial statements in a bid to dress up their earnings. In reality, however, healthcare companies which run hospitals and clinics, for example, should, in fact, add depreciation and amortization cost as part of their expense as medical equipment usually have a fixed operating life, and should be depreciated accordingly.

Other sectors, such as the technology industry, have also begun using EBITDA, as a measure to inflate their earning numbers. These companies with relatively little property assets should be using the standard EBIT (Earnings Before Interest and Tax) or income metric to measure profits, as this would give a better reflection of the company’s performance.

Investors should also be aware that EBITDA, EBIT and standard earnings are not interchangeable metrics. When comparing two company’s prices, it is important that we do not compare one company’s EBITDA with another company’s standard earnings, as this is not a fair comparison. For example, EBITDA-to-price ratios can make companies look much cheaper than they really are.

The Foolish Bottom Line

Warren Buffett once said, “It amazes me how widespread the use of EBITDA has become. People try to dress up financial statements with it.”

As investors, we should be aware of the flaws of using EBITDA as a metric to gauge the profitability of a company. Shrewd investors should be wary of companies that constantly tout their EBITDA numbers despite operating in industries that do not warrant such accounting measures.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn't own shares in any companies mentioned.