Before we begin, let’s take minute to appreciate Paulie explaining the EBITDA in the Sapranos:
I am sure you have heard EBITDA many times and that, as Paulie explained above, it represents a true picture of a company's profitability. It is easy to understand by definition and equally easy to calculate. I am writing this short post to explain the why of it. Let’s jump right into it.
But first, a quick recap on the how
It is indeed remarkably simple to calculate EBITDA. We take the net profit of a business and add back interest, tax, depreciation, and amortisation. The only thing to remember is to make sure that the interest, tax, depreciation, and amortisation were first deducted to arrive at the net profit. If our net profit is not calculated after deducting these items then, obviously, we will not add them back. Below is an illustration to visualise the same:
Please note that the EBITDA amount calculated above is equal to the amount of Operating Profit. Hence, in some industries, the term EBITDA is used interchangeably with Operating Profit. Also, we don’t need to first calculate net profit and then add back interest, tax, depreciation, and amortisation to calculate EBITDA. We can simply stop at the point when these items are not deducted from the profit and call it EBITDA.
When will this post will add some value to the topic?
Honestly, the one value I can add is to show you the way Paulie says “amortisation.” However, I could attempt to explain the why of calculating EBITDA.
Simply put, the EBITDA is calculated because the amounts of interest, tax, depreciation, and amortisation eat into a company’s profit but does not relate with business efficiency or effectiveness. Hence, EBITDA makes it possible for us to compare profitability of two similar businesses. Consider the following example:
In the above example, let’s assume that both firms are operating in the same industry and engaged in similar businesses. At one glance, we see that firm B is not only generating more net profit (32 compared with 15) but also is earning more profit as a per cent of sale. Firm A’s net profit is 15% of its sales and Firm B’s net profit is 21.33% of its sales. Does that mean that Firm B is more efficient? Of course, the answer is ‘no’, and that Firm A is more efficient. Even though these are similar businesses, net profit is not apple to apple comparison, because:
Interest
Both firms pay interest @ 4% and their interest amounts are also equal. However, given that Firm B’s sales are 50% more than Firm A’s sales, we are told that Firm B is more capitalised but have lower loans in their balance sheet. Hence, Firm B's interest payment is equal to Firm A's but has no impact on its efficiency. Therefore, we add interest back into net profit because a firm’s leverage has nothing to do with business efficiency.
Tax
In our example, even though both firms are running in similar businesses, they are taxed at different rate. This could be because of government regulations or operating in separate locations. Hence, taxes have no impact on how efficiently the businesses and must be added back to net profit.
Depreciation and amortisation
Lastly, we add back depreciation and amortisation amount to net profit because they are non-cash transactions. Moreover, in our example, both firms have equal amount of depreciation. However, we know Firm B is higher capitalised, therefore, Firm B should have more equipment and a higher depreciation amount. Two reasons for this equal amount could be: 1) that Firm B is depreciating equipment at a lower rate, and/or 2) that Firm B’s equipment is older and using the written-down-valuation method has equal amount of depreciation as Firm A. Hence, we add back depreciation amount to net profit to cancel out the bias of equipment age, rate of depreciation, etc.
After adding the above three amounts to net profit, our EBITDA or Operating Profit is 50 for Firm A i.e. 50% of its sales and 70 for Firm B i.e. 46.67% of its sales. Now we see that, although it has the lower amount of net profit, Firm A is more efficient.
Is this all there is to make two firms’ profit comparable
Sometimes we could also calculate EBITDAR, where ‘R’ stands for rent expense. One place this is useful to make profits comparable is where one business owns its place of business and the other is paying high amount of rent.
Is there all to learn about EBITDA
I believe that the most important thing to learn here is that EBITDA shows us how we exclude non-operating expenses from our profit to understand the true profit a firm earns as a going concern. While EBITDA is the most common term used in this context, the fact is that it is just a starting point. In practice, we must do a deep dive into a company's financial statements to find and exclude all non-operating incomes and expenses. One rule of thumb that can be used is whether a transaction if one-time in nature or recurring as part of business activities. These one-time transactions are also called "extraordinary transactions." Some examples could be, profit due to sale of assets or expenses incurred to settle a legal case.
Going forward I encourage you to pay attention to analyst comments when mentioning a firm's financial results. Another popular place where extraordinary items would be highlighted is the "Management Discussion & Analysis" section in a financial report. So the next you hear, "Firm Z reported 100% growth in profits year on year, however, 70% of the growth can be attributed to profits earned from sale of its DC location business," you would know that sale of DC location business is an extraordinary item which has no impact on the efficiency of the firm.
Comentários