Operating Profit (EBIT)
Earnings before interest, taxes,
depreciation, and amortization came into wide use among private capital
firms calculating what to pay for a business.
The private capital firms that originally employed it as a useful
valuation tool removed interest, taxes, depreciation, and amortization from
their earnings calculations in order to replace them with their own
presumably more precise numbers:
- They removed Taxes and Interest because they wanted to substitute
their own tax-rate calculations and the financing costs they expected under
a new capital structure.
- Amortization was excluded because it measured the cost of
intangible assets acquired in some earlier period, including goodwill,
rather than any current expenditure of cash.
- Depreciation, an indirect and backward-looking measure of capital
expenditure, was excluded and replaced with an estimate of future capital
Later, many public companies, analysts and journalists have urged investors
to also use EBITDA as a measure of the cash public companies generate.
It is often compared to cash flow because it rightfully adds back to net
income two major expense categories that have no impact on cash:
depreciation and amortization.
Yet it is a very poor and even misleading mechanism if it is used to
approximate cash flows of public companies! Why?
1. It excludes taxes and interest, which are real cash items and not at
all optional—a company must obviously pay its taxes and loans.
2. On the other hand, it does not exclude all non-cash items, only
depreciation and amortization. Among the non-cash items not adjusted for
in EBITDA are bad-debt allowances, inventory write-downs, and the cost
of stock options granted.
3. Unlike proper measures of cash flow, it ignores changes in working
capital. Additional investments in working capital consume cash.
4. Finally, the main flaw of it is in the E (Earnings). If a public
company has over- or under-reserved for warranty costs, restructuring
expenses, or bad-debt allowances, its earnings will be skewed and its
EBITDA misleading. If it has recognized revenue prematurely or disguised
ordinary costs as capital investments, its numbers are suspect. If it
has inflated revenue through round-trip asset trades, the E is of no
Book: Steven M. Bragg - Business Ratios and Formulas : A Comprehensive
Book: Ciaran Walsh - Key Management Ratios -
Compare with EBITDA:
| P/E Ratio |
Economic Value Added |
Economic Margin |
Cash Ratio |
Current Ratio |
Earnings Per Share |
Return on Equity |
Return on Invested Capital |
Added | CFROI |
Fair Value |
Relative Value of Growth
More valuation methodologies
Traditional Income Measure
(Residual Income Component)