What is EBITDA?

Earnings before interest, taxes, depreciation and amortization or, to give it its acronym, EBITDA, is a measure of a company's cash flow before certain deductions. It allows investors to see how much money a company is making before taxes, depreciation and amortization have been deducted. Basically, when investors place money in a company, they will want to know how much money the company has been making since their money was invested. This measurement gives the investor an idea of how much money the company has made before its deductions. It is especially useful for a new company that has just started business and has not yet been hit with taxes, payments to creditors, and so on.

If the EBITDA seems to have a good growth rate, then some investors may use this number 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. Investors call this looking at the EBITDA margin rather than the net margin.

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

EBITDA neglects several factors, including the money required for working capital, fixed expenses and other debt payments, and capital expenditures. In every business, capital expenditures are a crucial, ongoing expense, but this is not factored into the figure, so investors need to be wary when using this measurement as a basis for a profit margin.

There are more reliable ways for investors to calculate a company's cash income. The Free Cash Flow (FCF) system, for example, is calculated by simply deducting capital expenditures from the business cash flow figure. This takes into account at least three of the factors that the EBITDA leaves out: inventory, receivables and capital expenditures such as property and equipment.

FCF is not an ideal solution, since it does not figure in the expenditure of debt. A lot of companies, when first formed, are also in a negative cash flow situation for many years while the company builds. This measurement may be a viable and more reliable figure for an investor to use, however.