EBITDA: How to calculate this key figure

To be able to correctly assess the success of your own company by international comparison, you require meaningful key figures. Profit and annual surplus are inherently very important values. However, some factors also have an effect on company profit which they cannot influence. To be able to better judge the success of company activities by comparison, many economists therefore ignore it and use other figures. One of these economic key figures is called EBITDA.

EBITDA can play a key role for a company’s taxation as well as in evaluation by external organisations. It gives information about the profitability of company activities, and for this reason it is also used to evaluate how creditworthy companies are. Some companies even deploy this key figure to determine manager salaries. The value gives a good impression of the profitability of company activities and leaves out those items that do not have anything to do with it. This includes:

• Interest costs and earnings: Loan interest and earnings from shares are dependent on the financial strategy of a company and do not directly have to do with its activities.
• Taxes: The taxes due depend on many different, often also extraneous factors, and do not say anything about the profitability of company processes.
• Depreciation: Depreciation on tangible assets and immaterial goods is the result of investments that a company wants to or has to make. They are therefore not meaningful when it comes to company processes in the strict sense.

EBITDA is therefore an indication of the status of sales within a company. As depreciation is not included, the key figure does not give any information about the success of a company overall. The expenses of a company naturally also include its depreciation. On the one hand, its assets continuously lose value and have to be replaced; on the other hand every company also has to invest to respond to changes in its economic environment or to achieve its growth objectives.

In addition to the "sole" EBITDA described, there is also the term adjusted or cleaned EBITDA. For this value, extraordinary costs and income are deducted from the company result, but not costs which are more closely related to the company activities – for example, depreciation on the investments used for this. However, there is no precise definition as to what is included in these extraordinary costs and earnings. The significance of this key figure is therefore also limited when comparing different companies.

Due to its limited significance when it comes to the overall success of a company, EBITDA has been subject to criticism in years gone by. The reason for this is that some companies have tried to disguise their poor financial position using the figure. As already mentioned, strictly speaking it gives no information about the financial situation of a company. For example, the internet company AOL Time Warner announced that their EBITDA was USD 9.8 (GBP 7.5) billion, and thereby tried to deflect attention from a loss of USD 54 (GBP 41) billion, which was not captured by this figure. As some companies went even further and tried to make company results more attractive under the guise of EBITDA, economists have also used a sarcastic acronym to describe it: “earnings before I tricked the dumb auditor”.

EBITDA is best calculated from the annual net profit (this value can be taken from the profit and loss calculation which is usually mandatory in businesses). The annual net profit describes the profit after taxes. This means all items that EBITDA does not include are deducted:

You therefore add on expenditure on taxes and interest as well as depreciation, or you deduct the relevant revenues from the result.

The EBITDA margin can ultimately also be calculated from EBITDA. It represents the relationship between EBITDA and sales.

We have chosen two fictitious companies for our example. Each has an annual net profit of £1 million. However, as both companies have their head offices in different countries and also pursue differing financial and investment strategies, there is also a variance between their EBITDA values.

Company 1:

Because there were no earnings in the tax, interest and depreciation items, these factors must be added in full for the EBITDA calculation. Finally, an extraordinary return is deducted for the cleaned EBITDA, which has a positive effect on the annual net profit. The second company has generated the same annual net profit, but is pursuing a completely different financial and investment strategy; it also has its head office in a different country with lower tax on profits.

As the second company has to pay less in taxes on the same annual net profit and also records lower costs on interest and depreciation, EBITDA comes out a little lower than for the first company. One would therefore attribute a lower success level in the business operations to the second company. For the second company the "adjusted" EBITDA also corresponds to the uncleaned one, as it did not register either extraordinary revenues or extraordinary expenses in the financial year.

Please note the legal disclaimer relating to this article.