What is EBITDA and why is it an important indicator for your investment decisions?

The EBITDA is one of the measures of a company's profitability. It differs from net profits because it does not consider expenses such as depreciation, amortization, taxes, and interest. Understanding EBITDA helps you make better business decisions and also as an investor in the Stock Market. In this article, we explain everything you need to know about this indicator and why it is important in the financial world, along with a practical example.

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a simple way to approximate a company's operating cash flow. EBITDA excludes certain non-cash expenses and is a measure to evaluate a company's operating profitability, i.e., the profits before paying the interest on the debt incurred, taxes, depreciation, and amortization.

The purpose of deducting these expenses is to reflect a company's financial performance without the impact of its capital structure and factors beyond the managers' control, such as taxes. This can be very favorable for making better decisions when considering which stocks to invest in.

Thus, EBITDA provides a clear picture of what the company is earning or losing in the core business. The main drawback of EBITDA is that financial expenses can make a big difference to the company's financial health, creating a misleading impression.

There are two main ways to calculate EBITDA. The first is:

EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization

The second is:

EBITDA = Operating Income + Depreciation + Amortization

All these variables can be found in the company's financial statements.

Suppose a company generates $10 million in revenue and incurs $5 million in cost of goods sold and another $2.5 million in general expenses (selling and administrative).

Depreciation and amortization expenses amount to $500,000, leading to operating income of $2 million. Interest expenses are $500,000, leaving a pre-tax profit of $1.5 million.

With a tax rate of 20%, net income amounts to $1.2 million after subtracting $300,000 in taxes. Adding depreciation, amortization, interest, and taxes back to net income, EBITDA amounts to $2.5 million.

EBITDA shows how well a company is managing its day-to-day operations, including major expenses like the cost of goods sold. For this reason, it is a good indicator for investors of the company's current state and potential, beyond financing and tax aspects. It is an alternative to net income that focuses on revenue and expense lines under the current management's control.

Thus, if EBITDA is positive and growing, the company is profitable and may be successful. If EBITDA is negative, the business may be at risk. It all depends on the stage the company is in.

It is common for early-stage and high-growth businesses like startups to have negative EBITDA for a few years, hoping it will grow strongly in the future.

EBITDA is also an excellent indicator for comparing the profitability of companies, considering their financial health over time, as it is not affected by debt levels and taxes that vary between countries.

Finally, it also provides a view of a company's solvency, as EBITDA can quickly estimate the cash flow available to your company. This can be used for debt repayment, interest, and taxes.

EBITDA is a useful measure to see how a company is doing in its operations, without considering debts or taxes. A positive EBITDA indicates that the company is generating profits in its main activity, which is important for investors and managers.

It also facilitates comparison between different companies, as it is not affected by debts or taxes in each country. Understanding EBITDA helps to evaluate the financial health and growth potential of a company.

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