Posted by mikeb on April 11, 2007
What the heck did I just say?
Earnings Before Interest, Taxes, Depreciation, and Amortization. If you need or would like more information on what EBITDA is and how it is calculated look here.
Okay, back to the thoughts at hand.
When companies base their net worth based on EBITDA it looks really good to potential investors. Why you ask? Because using this model it does not take accounting and financing decisions into the picture. The tendency here is to believe that the higher the sales ratio the higher the profitability of the company in question when compared to others in the industry that company is in. EBITDA however is a good tool to analyze trends over a period of time in a specific industry. Again, this is because it removes the impact of accounting and financing decisions made by the companies in question.
When you are making a decision to start working for a company, buy stock in the company, invest in a company in other manners, or purchase a company using EBITDA is a very BAD thing to do. Though you can identify trends of competitors you are not taking into account the accounting and financing practices of the company. EBITDA should NOT be used as a way to measure cash flow for a company. Often it is however and this is where the issues start. The smart thing to do to truly judge profitability is to use Operating Cash Flow as the measure of profitability for the company in question. This will tell investors/employees if the company is losing money because it is unable to sell it’s product or is “in the hole” because of financing/accounting issues.
The problem is many will use EBITDA to make their decisions because it is easier to calculate than adding back in deductions and amortizations. This can turn ugly when the purchasing investor finds out that the costs of financing/accounting outweigh the perceived benefits of EBITDA.
Sorry, deep topic today and I barely touched the surface.