What is EBITDA?
In the financial and accounting world, we are confronted daily with a paraphernalia of acronyms and terminologies. One of the most prevalent is EBITDA. And for any entrepreneur, manager or accountant in Portugal, understanding it is not just relevant: it' s essential.
EBITDA is the acronym for "Earnings Before Interest, Taxes, Depreciation and Amortization".
As well as being a crucial indicator of a company's operating performance, EBITDA is a measure that reflects the generation of cash flow from pure operating activities, without the influence of financial operations and external factors.
But let's go in parts.
If you've come to this article because you own a company and want to master the concept, start by reading the section below and find out how to apply EBITDA to benefit the financial health of your business.
What EBITDA is for
The simple answer: it gives us an accurate idea of a company's operational performance.
In essence, EBITDA refers to the profit a company generates from its operations, disregarding financial expenses, taxes and wear and tear on assets, whether tangible or intangible.
In a competitive and ever-changing economic scenario such as the one we live in, EBITDA allows for a more homogeneous comparison between companies - even if they operate in different sectors or are under different tax regimes.
Let's analyze the usefulness of this indicator point by point:
1 - Allows you to calculate a company's performance
EBITDA acts as a financial thermometer, allowing entrepreneurs and managers to take the temperature of a company. By isolating operating income from non-operating expenses, EBITDA provides a true picture of the efficiency and productivity of the business under analysis.
Simple, right?
The great advantage is that by understanding EBITDA, it is possible to: identify trends, make projections and make more informed decisions - ensuring that management is aligned with the company's performance objectives.
Remember that this is a tool that allows managers to monitor the company's values and performance over time. Naturally, this ability will enable the analyst to make better decisions in terms of investments and operations.
But there's more!
2 - Allows an objective analysis of business circumstances
With EBITDA, the focus is on day-to-day operations. It is devoid of factors such as capital structures and tax regimes, which often distort the analysis exercise. For this reason, it provides us with a solid, unbiased basis for assessing the internal workings of a company, which is particularly useful in audits and performance reviews.
This objective approach to calculation also excludes amortization costs and various financial effects, reinforcing the indicator's usefulness as a measure of comparison between different entities in the market.
3 - Allows you to compare your company to others
Regardless of the size of the company or the sector in which it operates, this metric establishes a common standard for comparison.
By excluding elements such as taxes and interest, EBITDA enables effective benchmarking between companies, providing a valuable perspective on where a company stands in relation to its competitors.
This comparability makes EBITDA an essential financial indicator for listed companies.
4 - It's a useful indicator for investors
Because it serves as a beacon: guiding them through the often murky waters of financial analysis. Investors use this metric to estimate a company's cash generation potential, which makes it crucial when evaluating possible investments. In other words: a robust EBITDA can indicate a healthy operation and, by extension, an attractive investment.
If you are thinking of acquiring or merging your company, remember that EBITDA is useful for evaluating companies in the growth phase that are not yet profitable but are generating a positive value - which could be a sign of future potential.
But let's say we need to use this indicator...
...how to calculate it in practice? What is the formula?
How is EBITDA calculated?
To calculate EBITDA:
- There is operating profit, also known as operating income, which reflects a company's profit before interest, taxes, depreciation and amortization;
- Depreciation and amortization expenses are added back to this figure, as EBITDA aims to measure operational efficiency without taking into account the effects of capital structure, tax policies or large investments in fixed assets.
By understanding this calculation process, we begin to see the usefulness of the concept as a crucial indicator for assessing a company's overheads and operational activity.
But let's dive into the "little" concepts that make up the understanding ofEBITDA:
Operating Profit
Operating profit is the starting point for calculating EBITDA. It represents the company's profits resulting from its operations, excluding non-operating expenses and income.
To illustrate: if an accounting firm in Portugal has an operating profit of 100,000 euros, this figure is the basis on which EBITDA is calculated.
Depreciation and Amortization
On the other hand, depreciation and amortization are the accounting expenses that spread the cost of an asset over its useful life. Sound complicated?
I'll give you an example: if a company buys a computer for the office, with an expected useful life of five years, for one thousand euros, the company can depreciate two hundred euros a year.
In the EBITDA calculation, these expenses are added back to operating profit to show the cash flow generated by operations, before these non-cash costs.
If they are not added to operating profit: excluding these expenses from the final EBITDA calculation offers an optimized perspective of net profit...
...freeing the results from the restrictions of intangible assets and allowing a purer assessment of operating cash.
I hope I'm not sounding too technical!
Cash Cycles and Average Sales Receipt Times (ASRM)
Cash cycles and their average maturities are crucial to understanding a company's operational liquidity and, consequently, EBITDA. They directly influence a company's ability tomeet its short-term obligations and reinvest in the business.
It's simple: no cash in hand... no purchases, no payments!
Let's take a practical example: a retail chain that manages to reduce its Average Sales Receipt Period (ASRMP) can significantly improve its cash cycle. This makes it more agile and able to respond to capital needs such as:
- Investments
- Payments to suppliers
- Payments to banks
- Rent payments or other operating costs
Understanding these cycles is fundamental for managing in the short term and for the company's long-term sustainability: they are directly reflected in a company's financial health and ability to carry out its operational activities.
But there's more!
Average Purchase Payment Period (PMPC)
Conversely to PMRV, PMPC (long live the acronyms!) refers to the average time it takes a company to pay its suppliers.
A long PMPC can be beneficial for the company's liquidity, as long as it doesn't jeopardize relations with suppliers.
Let's look at an example of this concept in practice: if a ceramics factory in northern Portugal manages to negotiate a 90-day PMPC with its clay suppliers, it can use this period to produce and sell its products before having to pay for the raw material.
Remember that invoicing programs, especially the new online tools, allow us to set the due date for the invoices we send!
And what is left out of the EBITDA calculation?
When calculating EBITDA, some elements are intentionally omitted in order to provide a clear picture of operating performance:
- Financial expenses and income (such as interest paid on loans or income from investments);
- Just like taxes;
- And the effect of any subsidy or tax incentive.
In addition, EBITDA does not take into account cash variations or capital expenditures that are vital to a company's long-term expansion. This means that while EBITDA may indicate operational success, it does not give a complete picture of a company's financial health.
Remember that a more in-depth analysis will be required for a full assessment.
The omission of the elements listed above is therefore not a loophole: but an intentional measure to focus the analysis on what is generated by the main activities, without distortions from financial costs or variable rates.
How to evaluate a company's EBITDA (more) accurately?
In this article, we've already looked at the formula for calculating EBITDA. But to evaluate it accurately, you need to look beyond the absolute number and understand it:
- The company's operational context (beyond the financial situation or net income);
- The industry in which the company operates;
- And the accounting standards applied.
It is also essential to compare EBITDA over time, to identify trends of growth or decline in operating cash generation. And of course: compare it with other EBITDAS, from similar companies in the same sector, to understand the company's competitive position.
This is analyzing in context and making a real reading. But, depending on the industry in which I operate, what value should I aim for?
What is the ideal EBITDA for a company?
There is no single EBITDA figure that is considered ideal for all companies, as it varies accordingly:
- With the sector;
- Company size;
- And a growth strategy.
However, a positive and growing EBITDA over time is often seen as a sign of operational health.
What's more, a consistently higher value compared to competitors can indicate a competitive advantage in terms of operational efficiency or pricing power.
Difference between EBITDA and EBIT
If you are a user of business analysis indicators, allow me to "separate" concepts. Starting with this one: EBITDA and EBIT are both financial performance indicators, but they differ in the elements that are excluded from the calculation.
EBIT (Earnings Before Interest and Taxes) takes depreciation and amortization expenses into account, unlike EBITDA.
This condition makes EBIT an indicator closer to net income, reflecting not only operational efficiency, but also the impact of investments in long-term assets.
Is EBITDA a good indicator?
Of course, it depends on what we're trying to evaluate.
But in abstract: yes, it can be a good indicator of a company's ability to generate operating cash flow. Remember, however, that you should use it in conjunction with other indicators for a complete financial assessment.
Finally, I'm going to tell you about three concepts that are "outside the bounds" of EBITDA, but which we will need in order to handle this indicator perfectly in its practical day-to-day use.
EBITDA margin
This is the ratio between EBITDA and total revenue, expressed as a percentage.
A high EBITDA margin can indicate good management of operating costs and expenses, while a low margin can suggest the opposite. This metric is especially useful for comparing the operational efficiency of companies within the same sector.
Net Debt
Net debt is an important factor to consider along with EBITDA, as it represents a company's total debts minus available cash.
A high EBITDA in relation to net debt may suggest that the company is well positioned to repay its debts, while a high net debt in relation to EBITDA may be cause for concern.
Adjusted EBITDA
Finally, Adjusted EBITDA excludes extraordinary items to give a more accurate view of ongoing operating activity, allowing for better decisions based on data that is more representative of the business activity and situation.
They are variations on the main concept and, at this point, I'm not interested in you mastering them, but at least getting to know them!
Conclusion
In short, EBITDA stands out as a valuable tool for understanding a company's financial health. By focusing on operating profit and cash flow, it offers a differentiated view which, when complemented with other analyses, can guide decision-making and financial operations.
Companies listed on the Stock Exchange often use EBITDA to communicate to investors the figures that reflect their financial situation and the information required by the Securities and Exchange Commission. If your company is listed on the stock exchange, you will probably (or usually) hear about it!
I hope this article has helped to bring some clarity to the concept and remember that BTOCNET is here if you need help in the process of financial analysis of a company you are looking to evaluate. See you soon!
