When investors and potential investors want to gauge the financial health of an organization, they will often use accounting methods referred to as the Generally Accepted Accounting Principles (GAAP). These are regulated and monitored accounting processes that will get results that can easily and accurately compare companies.
But GAAP methods also take into account a lot of elements that investors consider to not be part of the real daily operations of a company. That is why some investors use numbers generated using the Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) method. But the EBITDA methods are not monitored or regulated, and investors have to really know what they are doing to get accurate information using these methods.
Utilizing Only Operating Income
One way to calculate EBITDA is to only utilize the company’s operating income. When this method is used, the formula looks like:
EBITDA = Reported Operating Profit + Amortized Expenses + Depreciated Expenses
With only the operating profit in this formula, other forms of income are left out. This allows the expenses to become more prominent as ways to offset losses. Companies usually try to avoid deception when using EBITDA, but when it is used in this way it is possible to boost the income in an artificial way and make it seem like the company’s cash flow is stronger than it really is.
Utilizing All Income And Expenses
Most companies use the full expression of EBITDA which looks like:
EBITDA = Taxes Paid or Scheduled to be Paid + Amortized Expenses + Depreciated Expenses + Net Profit + Interest From Investments
This version of EBITDA not only takes into account the company’s income from core operations, but it also allows for interest received due to investments. This method also allows for one-time income events such as the sale of equipment or real estate to be considered part of the company’s cash flow. While this form of the calculation is not necessarily wrong as the proceeds from investments are often considered cash gains, it can be a little misleading when it comes to the real day-to-day operational health of the company.
The EBITDA is used by investors of all types to attempt to get an accurate picture of a company’s daily financial health. In the business world, strong and reliable cash flow is considered the sign of good health and that is what the EBITDA is supposed to measure.
But since the EBITDA is a non-GAAP calculation, it comes with a certain amount of risk to investors. While the numbers might add up within the formula, there is no guarantee that the numbers being used are complete. Since the EBITDA can be manipulated in many different ways, it tends to be a tool used only as part of a financial evaluation and not as a complete indicator on its own.
Jim Treebold is a North Carolina based writer. He lives by the mantra of “Learn 1 new thing each day”! Jim loves to write, read, pedal around on his electric bike and dream of big things. Drop him a line if you like his writing, he loves hearing from his readers!