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Why do investors look at EBITDA

The ins and outs of EBITDA

Ever hear of EBITDA or EBIT in the investor space? Ever wondered what EBITDA means? If you're interested in investing then you need to know what EBITDA is and how to use it.

The basics of EBITDA

EBITDA originates from accounting and stands for Earnings Before Interest, Tax, Depreciation and Amortisation. It refer to a particular line in a Company's Profit and Loss statement. If you work your way down a company's Profit and Loss statement you will start with Sales at the top, minus Cost of sales (what it cost to produce that revenue). These together equal Gross Profit. If you minus from this figure all of your Overhead (essentially all of your administration costs that cannot be attributed to a particular sale such as rent on the office building) then you are left with Operating profit and this is sometimes referred to as EBITDA. It is the profits of the Company before considering any interest income or interest costs, any dividends, any depreciation and any amortisation.

Note that depreciation and amortisation are the cost of big investments such as machinery, buildings or even brands and licences that are spread out over a reasonable lifetime of the assets' existence.

Why do investors look at EBITDA?

Investors are only ever interested in cash. Accountants are the ones who are interested in bottom line cash. Investors put money into Companies that they consider are cash generative enough to pay a decent and predictable return in the form of a dividend. Cash truly is king. If a Company isn't producing cash then it's not worth investing in.  EBITDA is a very useful proxy for the cash generative abilities of a Company. It is an indicator of the Companies current cash production from its existing operations. It is asking the question: if there was no additional investment to be made by the Company and no finance costs, what would the existing business produce in terms of cash over a specific time period?

Problems with EBITDA

There are a couple of issues with a EBITDA. Whilst it is an estimate of the Company's ability to produce operating cash it ignores working capital timing differences. For example, I might have made a sale to you for £1,000,000. However, to secure the sale I may have given you two months to pay. This will cause a two month delay in my operating cash such that in reality if you looked at my cash today it is actually £1,000,000 lower than it ought to be when compared to the sales I've made.

Additionally, as EBITDA ignore capital spending on fixed assets such as machinery and buildings, it may not capture the fact that to grow or even just to run the business effectively regular investments will need to be made. This ignores the requirement for large cash outlays to be made.

Caution as always with financial metrics

As noted before in previous articles. When dealing with financial metrics never look at them in isolation. Use EBITDA as a starting point for understanding the cash generative ability of the business. However, you must look at other areas where the business is forced to spend cash. Additionally, investigate other metrics to understand whether the Company is a viable investment.

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