EBITDA, Net Income and Approaches to Measure Company Performance

EBITDA can be a contentious accounting topic that brings a spirited debate with seemingly equal evidence for and against. We will not try to settle the debate centered around EBITDA's usefulness, but we will rely on our CFO, Keith Haas, to reveal why companies may choose to report EBITDA and what it can and cannot measure about the business. 

What ways can companies report EBITDA and EBIT?

EBITDA is defined as earnings before interest, taxes, depreciation and amortization.  Usually companies report EBITDA one of two ways. The first is by excluding D&A in the income statement to produce EBIT. Start with revenues, subtract direct costs or cost of goods sold, then deduct all the operating expenses and arrive at operating profit.  If the operating expenses don't include any depreciation or amortization, then operating profit in the P&L is the same as EBITDA. So that's a good approach for internal reporting and evaluating business performance month-to-month.

The other way to calculate EBITDA is more of an accountant’s approach. You start with net income and then you add back to net income: interest, taxes, depreciation and amortization. Accountants like to reconcile things and this approach is required for SEC filings - it proves the calculation of EBITDA, a non-GAAP measure to a GAAP measure, Net Income. Adding back items can be more precise - think completeness - but harder to compare performance because you need to compare both the income and the add-backs.

For most companies, the former approach works best - exclude depreciation amortization from the income statement expense accounts. All in all, EBITDA is a good performance measure because it is relatively easy to understand and includes the manageable or controllable expenses of the company.  

Considering EBITDA over operating income

The primary reason to use EBITDA is if there is a meaningful amount of depreciation or amortization in the Business that is not relevant to operating performance. 

Some stakeholders will argue that EBITDA is insufficient or incomplete because it excludes ITD or A - it depends upon your business and whether those items are meaningful. One example would be a manufacturing business with a lot of equipment and hard assets that depreciate over time. Those costs are simply too significant to ignore. 

Adjusted EBITDA

EBITDA helps one look at the business on a cash basis - and cash flow is critical to fund investment and pay down debt. EBITDA can facilitate comparisons of performance by eliminating non-cash items that may be irrelevant to a comparison - e.g. intangible asset amortization from a long ago acquisition.

Beyond EBITDA, there is Adjusted EBITDA.  Companies may choose to adjust EBITDA to exclude certain one-time or non-recurring expenses. There is some flexibility here, but that also means it is important to be transparent and consistent in your reporting.

Common adjustments to EBITDA include:

  • Restructuring costs - one-time 
  • Large litigation expenses 
  • Gains or losses from the sale of assets or litigation
  • Asset impairment charges
  • Stock compensation expense. 

Adjusted EBITDA provides a clearer picture of the ongoing, sustainable operating performance of the business. For each of the above, there is a valid rationale or set of facts and circumstances for NOT adjusting.  This is why the context in the narrative or commentary is critical.

Why decide to report EBITDA?

Generally speaking, there are four primary reasons to report EBITDA. 

First is that EBITDA makes it possible to compare companies or entities with different financing structures or tax burdens similarly.  

Second, EBITDA is a preferred method of analysts and investors utilizing finance ratios, bank covenants and other required reports to demonstrate the operational health and ability to service debt.  used in calculations of financial ratios, such as the debt-to-EBITDA ratio.

Third, EBITDA is necessary for valuation purposes when considering a merger or acquisition. Since it is a common use of measure in business, it streamlines due diligence and how a company’s value is assessed. 

Lastly, EBITDA  is useful in simplifying complex capital structures, where a company may have a substantial debt or tax burden, and complex investor capitalization table. In these circumstances, EBITDA provides insight into the performance of the business excluding these specific factors. 

Why investors like Warren Buffett and Charlie Munger oppose EBITDA

Most of Charlie Munger (RIP) and Warren Buffett's Investments are in industrial companies or retail organizations and those businesses are capital intensive and require a large asset base to generate revenues and profits. A company’s value is highly dependent upon capital efficiency. 

Take two different investment profiles. You may have one company that has invested a significant amount of capital into its assets, real estate, plant or machinery and that company needs to generate a much higher level of EBITDA to provide an adequate return on that amount of capital.

EBITDA also ignores the cost of working capital. Businesses that have a high investment in working capital (accounts receivable, inventory, etc.) need to manage that working capital and of course EBITDA does not reflect any cost of working capital.  So for a business that is more capital intensive due to asset or working capital investments, EBITDA by itself is insufficient.

Capital intensive businesses are better evaluated using broader measures like return on assets or economic profit. These more complex measures factor in asset utilization.  Return on assets is the ratio of net income to total assets. Return on assets can be benchmarked against different size businesses and more capital efficient businesses have a higher return on assets.  

Economic Profit starts with a measure like EBITDA and has an additional cost for the working capital and assets the business deploys - these assets are charged at the cost of capital, almost as if you were renting them.  Managing growth in Economic Profit can be very effective for capital intensive companies and help management make trade-offs between operating and capital efficiencies.  We can cover this more in a future chat.

Should CFOs focus on EBITDA or another performance metric?

For any company, it's critical to identify a set of measures that will help guide management and provide feedback on the company's performance, with the ultimate objective of creating a valuable business. EBITDA is more about simplicity. It is a great way to start building business acumen within a company. If you are already there, more comprehensive measures can be introduced.

For a growth company, measures should reflect the sources of growth. Consider leading indicators around sales and go-to-market efficiency and lagging metrics, such as new logos and logo retention.  Tie these to revenue metrics such as bookings, upsell, and cross sell.  

Investors are no longer interested in growth at any cost and that is where EBITDA can come into play.  EBITDA will help focus the team on the trade-off between growth and investment.  So in addition to your cost to acquire customers, or CAC, and return on sales and marketing spend, EBITDA is a great comprehensive measure to capture how much cash the company is generating or burning in any one period.

The bottom line - calculating and tracking EBITDA can be valuable to help you pinpoint the drivers of expenses and health of the business operations. If you have yet to measure your organization's EBITDA, or are in need of assistance, both from a technology and service perspective, FutureView could be the solution for you.