EBITDA: CNBC Explains

EBITDA may sound like a punch line from a Three Stooges film, but it's really an important tool for investors to figure out if a company that's taken their money is doing well or not. CNBC explains.

iStock photo

What is EBITDA?

It's an acronym for "earnings before interest, taxes, depreciation and amortization"—EBITDA.

What EBITDA does is measure a company's net income before certain deductions. The idea behind it is to show how much money a company is making before taxes, depreciation and amortization have been deducted.

Breaking it all down, interest is what a company earns from its investments. The tax part of EBITDA is straightforward in meaning—what a company owes the IRS. Depreciation and amortization are accounting ways to reduce the costs of equipment, buildings, tools and even a company's good name or reputation.

So if you had a formula, it would look like this: EBITDA = (equals) Revenues — (minus) interest, taxes, depreciation, amortization.

It's important to note EBITDA does not reflect cash flow, as we'll explain a bit more later.

Why is EBITDA important?

When investors put their money in a company, they want to know how much money the company has been making. EBITDA gives the investor some idea before deductions are taken.

EBITDA is especially useful for a new company who has just started business and has not yet been hit with taxes, payments to creditors, and so on.

If the EBITDA figure seems to have a good growth rate, then some investors may use this figure instead of the overall net figure. It can show them that the company has a future for potential growth and that they will get a return on their investment.

There are problems in using EDITDA. It leaves out of lot of expenses in the final figure, so it may not be a realistic view of a company’s profitability. And that means it does not measure the actual cash that is flowing into the company.

When did EBITDA come about?

EBITDA first became popular with leveraged buyouts in the 1980s. It was used to indicate the ability of a company to service debt.

As time passed, it became popular in industries with expensive assets that had to be written down over long periods of time. EBITDA is now commonly quoted by many companies, especially in the tech sector because they're usually newer companies.