EBITDA (Earnings before deducting interest, tax depreciation and amortization) is a metric used to showcase a company’s financial performance excluding the impact of its capital structure and investment decisions. It shows how much a company is able retain from its topline after reducing expenses related to operations.
While this is not part of GAAP (Generally Accepted Accounting Principles), it is widely used for analyzing a company’s performance as it helps in assessing the operational performance.
There is a correlation while analyzing unit economics with EBITDA. Evaluating revenues and costs on a per unit basis helps to identify points of improvement, which will helps enhance operational efficiency.
EBITDA may not be the right metric to compare companies from the same industry if the Capex structure differs significantly. To address this, the concept of Adjusted EBITDA has emerged to create a more suitable basis for comparison.
What is adjusted EBITDA?
It is a spinoff of the traditional EBITDA, wherein adjustments are made to EBITDA to exclude extraordinary and non-recurring items.
How is it used?
A practical example of where to use this can be for comparing EBITDA of D-mart and Reliance. D-mart stores are owned by D-mart, whereas Reliance retail stores are rented. So even though both are in the same industry, it would not be appropriate to compare the EBITDA of these two companies as rent is an expense that will be included in the EBITDA of Reliance retail, at the same time D-mart will have a higher depreciation and finance cost as they would have spent heavily on CAPEX investments. To make these two companies comparable we could use EBT or EBITDAR (rent), which is adjusted EBITDA.
Gaining popularity of Adjusted EBITDA
These are some of the news headlines in the past few months:
1/ “Zomato turns adjusted EBITDA positive in Q4FY23; Blinkit still in red”
2/ “PB Fintech (Policybazaar) Q4 results today. Hopes of firm turning adjusted Ebitda positive to keep its shares buzzing”
3/ “Indonesia tech firm GoTo expects positive adjusted EBITDA in Q4, 2023”
4/ “Uber Announces Results for Fourth Quarter and Full Year 2022. Mobility Gross Bookings, Adjusted EBITDA and Adjusted EBITDA margin at all-time quarterly highs”
The above reports show how companies are able to better portray their financial performance after adjusting for abnormalities using adjusted EBITDA, and this is also a reason why it’s been popularly used by companies while disclosing their financial results.
Ratio analysis using EBITDA
1/ Debt service coverage ratio: This ratio assesses the company’s ability to cover its fixed obligation from its operational profit. This ratio is often compared by debt providers to analyze the repayment capacity of the borrower.. The downside to this ratio is that debt providers often confuse EBITDA with cashflow. While EBITDA is a good metric to evaluate profitability and operational efficiency, it is not always a healthy measure of cash flow, nor does it ensure that cash flow is guaranteed to follow.
For example: Adani Enterprise has a Debt service coverage ratio of 4.29, which indicates that operating profits is can cover 4 times its current fixed obligation. Any ratio below 1 indicates that the operational profits are not enough to cover the fixed obligation.
2/ EBITDA-to-Asset ratio: EBITDA-to-Asset ratio is crucial for companies with asset heavy balance sheets. It measures operational efficiency in converting assets into revenue. Investors use this ratio to evaluate a company’s ability to leverage assets effectively for generating earnings.
Indigo’s EBITDA to asset ratio for March 2023 stands at 13.41%. This implies that with its entire assets, Indigo generated an operating profit EBITDA of 13.41%. This is a substantial increase from the 2.74% ratio in March 2022.
3/ CFO/EBITDA (Cash flow from operations to EBITDA ratio): While EBITDA focuses on operating profit, CFO/EBITDA ratio shows the company’s ability to translate these profits into actual cashflow and hence it is a key metric that should be tracked.
But this ratio too has its own limitations. In most of the SaaS companies, subscription charges are collected at the initiation of the service and expense is incurred over time. As per GAAP, revenue is to be recognized over the period of subscription. In this type of transaction, where cash is collected in advance would lead to high CFO and evaluation based on CFO/EBITDA may not be appropriate at a monthly level in which case annual ratios would help normalize.
Ed-tech gaint Byju’s had changed their revenue recognition policy in FY 21 on “streaming services” from recognizing the entire revenue on commencement of a contract to recognizing revenue on a pro rata basis over the term of the contract, resulting in a significant decline in reported revenue. As a result, metrics like the CFO/EBITDA ratio became less meaningful, as operating cash flow remained high while reported revenue decreased.
4/ EBITDA to Sales ratio/ EBITDA: This ratio is indicates how much of the revenue a company retains after deducting its operational expenses to earn such revenue. This ratio is used to compare the performance of a company with its competitors. A higher EBITDA to sales ratio indicates that the company is able to optimize its costs better when compared to its competitors.
Valuation using EBITDA multiple
Financial analysts use EBITDA multiple determine a company’s value. This is done by comparing the recent transactions of similar company or industry benchmarks.
For a company in its growth phase, using EBITDA at the year-end may not be prudent as the company might have grown rapidly since that time. Hence Trailing twelve-month EBITDA (TTM EBITDA) used for valuation of companies as it is focused on the most recent operating performance.
How do stock traders use EV/EBITDA multiple for making investment decisions?
EV/EBITDA (Enterprise value/ EBITDA) is commonly used by financial analysts to compare multiple investment opportunities. It measures the relationship between a company’s EV and operating profit. Thus, a low EV/EBITDA ratio will indicate that the company is able to generate more value for the investor, it also indicates that a stock is undervalued/ priced at its intrinsic value. A high EV/EBITDA ratio will indicate that there is a potential that the company is overvalued.
EBITDA is a very crucial metric for investors as well as management. To an investor EBITDA provides a snapshot of operational profitability and this allows for a clearer comparison between companies in the same industry and portrays a company’s ability to generate cash from its core operations. For management, EBITDA is a valuable metric as it aids in making strategic decision and assessing debt servicing capacity of the company.
While a higher EBITDA is a positive indicator it is important to dive deep into how it has been achieved. An improvement in EBITDA can be achieved through either improving revenue or decreasing costs. If the growth is due to increase in revenue it indicates that the company is able to capture more of the market share or it indicates a growth in the market size. On the other hand, if EBITDA growth is driven by cost reduction, it's essential to assess whether this stems from a decrease in core operational expenses or administrative costs. A reduction in core operational costs signifies an improvement in operational efficiency, while a decrease in administrative costs can contribute to a more favourable, it is imperative to assess the sustainability of this cost reduction strategy, especially if it involves significant layoffs in the short run.
Simultaneously, a lower EBITDA might not necessarily be a negative indicator. If the company is prioritizing growth, it is expected to allocate more resources towards marketing and business development, with the anticipation of achieving a healthy EBITDA in the future.