If analyzing the financial strength of a company were easy, then we'd all be named Warren Buffett. Instead, investors must dig through a mound of financial data and indicators that are not only confusing, but often conflicting. Sometimes the very same quarterly earnings report will paint two very different pictures of a company's performance based on competing calculations. As investors, which one of those calculations should we believe?
Depending on whom you ask, a revenue calculation called EBITDA is either an excellent way to compare the financial strength of two companies or nothing more than a cheap accounting trick. The truth, as usual, is somewhere in between. EBITDA stands for earnings before interest, taxes, depreciation and amortization. But before we get into the details of EBITDA, let's cover the some accounting basics first.
The standard method for calculating a company's profit is to figure out its net income. The simple definition of net income is gross revenue (every dollar the company earns) minus expenses (every dollar the company spends). When we think of expenses, we typically think of the cost of raw materials, manufacturing costs, rent on office space, employee salaries and other tangible costs of running a business. But companies have lots of ways of spending money. When a company borrows money, it must pay interest on those loans. In addition, the vast majority of companies pay taxes, and most companies use accounting principles like depreciation and amortization to spread the expense of big-ticket items over time.
According to generally accepted accounting principles (GAAP), the standard way of calculating net income (revenue minus expenses) is the only way. But in the 1980s, a new breed of companies specializing in leveraged buyouts (an especially risky type of hostile takeover) began popularizing the use of EBITDA as a more accurate measure of long-term profitability [source: Investopedia]. The argument is that EBITDA -- by ignoring expenses like interest, taxes, depreciation and amortization -- strips away all of the costs that aren't directly related to the core operations of a company. What is left, say the supporters of EBITDA, is a purer measure of a company's ability to make money.
The truth is that EBITDA, if used to make "apple-to-apple" comparisons of two traditional business (like manufacturing or retail), can be very helpful [source: Smith]. EBITDA reduces the financial noise down to a single number that represents ongoing income from a company's core business operations. The problem, as we'll discuss on the next page, is that EBITDA has a history of being used by high-risk, non-traditional businesses to take a bad investment and paint it gold.