EBITDA and EBITDA margin

The EBITDA is a well-known financial metric. It is considered as the best approximation of operating cash flows and thus consequently a crucial indicator for managers, bankers, appraisers, analysts and other industry practitioners.

In other words, EBITDA gives you an indication of how much earnings before interest, taxes, depreciation and amortization the company makes with all the invested capital. Negative number is a red alarm for a company, meaning that the company is facing fundamental problems with its operations.

Normally practitioners consider normalized EBITDA only (management adjustments, pro-forma adjustments and other adjustments), since one off events may sometimes represent a significant role.

Due to fast and easy use of EBITDA, the metric is dominating the financial world. Its applicability makes it a #No.1 indicator. Furthermore, it is often used in relation with debt, value and performance indicators:

Leverage: Financial obligation/EBITDA

This metric measures how does the debt relate to the ability of generating the operational profit. It can be argued that a leverage > 4 is not acceptable for banks anymore.

Interest coverage: EBITDA / Interest expenses

This metric measures the ability of a company to cover its interest out of its operations. It is obvious that a ratio <1 is not sustainable.

Value multiplier: Enterprise value/EBITDA (EV/EBITDA)

This metric measures how the market values the firm according to its ability to generate operational profits.

Performance indicator: EBITDA / Total revenues (EBITDA margin)

This metric is a relative indicator and offers a great way to compare the company performance with its competitors.

EBITDA is further developed into EBITDAR and EBITDARM in cases where costs such as rents, restructuring fees and management fees represent a significant amount. These is especially typical for retail industry, REITs, hospitals, etc.

Nowadays more and more financial practitioners are aware of the underlying interpretational problems of EBITDA. The metric that overcomes the disadvantages of EBITDA is the economic value added model (so called EVA model). Even though the model as such is more advance, it relays on subjective assumptions related to the cost of capital calculation.

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