Speaking the language of Finance – EBITDA

In the first of our irregular series on financial terminology, we looked at earnings and PE ratios. Very much linked to that, today we’ll look at EBITDA and some related acronyms.

EBITDA stands for earnings before interest, tax,  depreciation and amortization.  So it is fundamentally an earnings or profit number, but taking out those elements that might be considered to be one-offs or variable factors – the interest the firm pays on any debt, the corporate tax charge, the depreciation charge related to capital investment, and amortization, which applies to writing off intangible assets such as goodwill or intellectual property, perhaps obtained as part of an acquisition of another firm. So the aim of EBITDA is to express some sort of underlying profitability of the organisation.

EBITDAR is also used at times, adding R for “rent” into the equation, which can be useful if comparing firms with different asset structures (perhaps one rents their premises, the other owns and makes capital expenditures). Some firms have even tried to throw marketing into the equation, and claim that some of those costs should not be considered when looking at the underlying profitability of the business. That seems to be stretching it too far, and hasn’t  had a very positive reaction from investors or commentators.

There are two points to note for procurement, (as well as the general benefit of being able to talk to finance people and top executives in a language they relate to)!  The first is exactly the same general point we covered last time – that the contribution from procurement has a direct effect on this number, and as in the case of other earnings ratios and measures that can play into the multiplier effect by which firms are valued.

The second is on the supplier side. Some firms show a good EBITDA. And certainly, looking at the inverse situation, a negative EBITDA indicates that a business has fundamental problems with profitability.  But if the firm is in debt, so the interest payment is high; or has made many acquisitions, and is writing off the cost of that (amortization), then it may show a healthy EBITDA whilst actually being in a perilous financial position.  Warren Buffett is one of many who have questioned the legitimacy of EBITDA – he asked  “Does management think the tooth fairy pays for capital expenditures”?

Anyway, if a supplier tells you not to worry about their balance sheet and the hefty loss they made last year, because “our EBITDA looks fine”, then do  take a look at just what the underlying causes of that might be. Many firms go bust because they can’t meet interest payments, for instance, so a healthy EBITDA does not necessarily mean a healthy and sustainable business.

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