What it is:
"EBITDA" is an acronym that stands for earnings before interest, taxes, depreciation, and amortization.

How it Works/Example:
To see how EBITDA is calculated, let's take a closer look at a hypothetical quarterly income statement for XYZ Corporation, which for the sake of this example we'll assume is a gaming company:

XYZ Corporation Income Statement
(All figures are in thousands)

Operating Income = $115,000 - $70,000 = 45,000
Interest Expense -- $12,000

Income from Continuing Operations
Before Income Taxes -- $33,000
Income Taxes -- $8,000
Net Income -- $25,000

From this information, we can easily determine the EBITDA that XYZ Corp. delivered in this particular quarter. To do so, we simply need to start with net income, and then add back interest, taxes, depreciation, and amortization:

Net Income -- $25,000

+ Interest -- $12,000
+ Taxes -- $8,000
+ Depreciation & Amortization -- $5,000

EBITDA -- $50,000

In this example, XYZ Corp. posted EBITDA of $50 million in the most recent quarter.

Why it Matters:
EBITDA was once used strictly to measure the creditworthiness of financially distressed companies. In theory, companies with high EBITDA could adequately cover their debt payments. The term became popular during the leveraged buyout (LBO) frenzy of the 1980s, before which EBIT (earnings before interest and taxes) was the standard. In time, though, EBITDA gradually evolved, and today it can frequently be seen in many firms' quarterly reports.

The use of EBITDA as a commonly reported financial measure varies from industry to industry. For some industries, it can be an appropriate measure, whereas it can be misleading for others. For this reason, some sectors such as telecommunications and gaming use it with regularity, yet it is rarely seen in others.

Because depreciation and amortization are non-cash charges, some view EBITDA as a better proxy than earnings of the actual cash that flows through a company. Essentially, EBITDA measures the core income that a company earns before it covers its debt payments and pays its income taxes. Occasionally, the term is even used interchangeably with operating cash flow. Investors should assess EBITDA with caution, though. While it can be a useful measure of gauge a company's profitability, it is often quite different from actual cash flow.

To begin, EBITDA doesn't take into account changes in working capital or capital expenditures. Also, it overlooks the frequency with which a firm must replace or upgrade its equipment in order to stay current. With this in mind, it may be appropriate as a measurement tool for companies with capital-intensive equipment that is depreciated over an extended period of twenty years or more. However, it can also be misleading to apply the same methodology to a firm with short-lived equipment that must be replaced every few years.

In conclusion, EBITDA can be a helpful metric under the right circumstances. Investors can also use this measure to compare the profit growth of companies that operate in different tax brackets. EBITDA can also assist lenders when estimating the cash flows that a company will have available to service its debt -- as it more or less measures the amount of cash that a company has available for interest payments. Finally, EBITDA can provide a truer cash flow picture in industries where substantial non-cash depreciation and amortization expenses might otherwise distort earnings figures.

However, EBITDA can also be deceptive when applied incorrectly, and is especially unsuitable for firms saddled with high debt loads or those subject to frequent upgrades of costly equipment. Furthermore, EBITDA can also be trumpeted by companies with poor earnings in an effort to "window-dress" their profitability. Notice in the example above that XYZ Corporation's EBITDA was twice as high as its reported net income.

Therefore, when analyzing a firm's EBITDA, it is best to do so in conjunction with other factors such as capital expenditures, changes in working capital requirements, debt payments, and, of course, net income.

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