There are a number of metrics available to measure profitability. EBITDA (earnings before interest, taxes, depreciation, and amortization) is one indicator of a company's financial performance and is used to determine the earning potential of a company. With EBITDA, factors like debt financing as well as depreciation, and amortization expenses are stripped out when calculating profitability.
Ways to Calculate EBITDA
There are two formulas for calculating EBITDA. The first formula uses operating income as the starting point, while the second formula uses net income. Both formulas have their benefits and drawbacks. The first formula is below:
Operating income is a company's profit after subtracting operating expenses or the costs of running the daily business. Operating income helps investors separate out the earnings for the company's operating performance by excluding interest and taxes.
- Operating income was $3 million, highlighted in blue.
- Depreciation was $141 million, but the $3 million in operating income includes subtracting the $141 million in depreciation. As a result, depreciation and amortization need to be added back into the operating income number during the EBITDA calculation.
- EBITDA was $144 million for the period or $141 million + $3 million.
- Net income posted a loss of -78 million for the quarter, highlighted in blue.
- Depreciation was $141 million, highlighted in red.
- Net interest expense was $78 million while the company had a credit or benefit from income taxes for $1 million, highlighted in green.
- EBITDA was $140 million or -$78 million + $141 million - $1 million + $78 million (net interest). Since income tax was originally a credit of $1 million, we deducted it back out to calculate EBITDA.
We can see from the above example that each EBITDA formula resulted in different profit numbers. The difference between the two EBITDA calculations can occur if companies have one-time adjustments like a credit from the sale of equipment or investment profits. As a result, both EBITDA formulas might yield slightly different results, and investors should be aware of what components make up the difference.
For JC Penney, the difference lies in the two numbers highlighted below. The pension income of $19 million and the loss from extinguishment of debt of $23 million netted out to the $4 million difference. As a result, the EBITDA formulas can yield different results depending on whether the calculation uses the net income or the operating income formula.
Bringing It All Together
EBITDA can be used to analyze and compare profitability among companies and industries as it eliminates the effects of financing and accounting decisions. Investors and analysts might want to use multiple profit metrics when analyzing the financial performance of a company since EBITDA does have some limitations.
As stated earlier, depreciation is not captured in EBITDA and can lead to distortions for companies with a significant amount of fixed assets. For example, oil companies have sizable amounts of fixed assets or property, plant, and equipment. As a result, the depreciation expense would be considerable, and with depreciation expenses removed, the earnings of the company would be inflated using EBITDA.
It's important to note that the calculation of EBITDA is not officially regulated allowing companies to massage the figure to make their company look more profitable. An unscrupulous company could use one calculation method one year and switch the calculation the following year if the second formula made the company appear more profitable. If the calculation method remains constant from year to year, EBITDA can be a very useful metric for comparing historical performance.
Compete Risk Free with $100,000 in Virtual Cash
Put your trading skills to the test with our FREE Stock Simulator. Compete with thousands of Investopedia traders and trade your way to the top! Submit trades in a virtual environment before you start risking your own money. Practice trading strategies so that when you're ready to enter the real market, you've had the practice you need. Try our Stock Simulator today >>