When evaluating a company to decide whether it’s a good investment, knowing how much it makes in profits would seem a straightforward factor to consider. But how to calculate that number is not that straightforward. One way that is often discussed is EBITDA, earnings before interest, taxes, depreciation, and amortisation.

“EBITDA can be a useful measure when assessing a company,” explains Richard Cayne of Meyer International. “However, you need to understand that EBITDA can reveal as much as it can conceal about a company’s value.”

What exactly is EBITDA?

A company’s earnings are an excellent indicator of its financial health. You can judge a its historic performance to predict future success or failure and compare it to how its peers are faring. But is that number a true representation of what a company is worth? EBITDA came into the fore in the 80s as a way to simplify a company’s cash position.

As in the breakdown of the acronym, EBITDA is a company’s earnings before interest, taxes, depreciation, and amortisation are deducted. Interest being that paid on debt, taxes being self-explanatory, depreciation being the decreased value of tangible assets such as operating equipment, and amortisation being the decreased value of intangible assets such as intellectual property.

EBITDA is not a cash flow indicator

While EBITDA may seem to show how much money a company has on hand during the year, it is not representative of a company’s cash, as some may think. As an analogy, consider your annual salary. While it may be an impressive number (or not), it isn’t what you take home or even save. There are taxes, debts, etc. to pay first, isn’t there?

But that is possibly why companies like to use EBITDA in their income statement. It often shows a positive result even when they are performing at a loss for that period. Another sign that EBITDA is not also a good gauge is the fact that it is not considered a generally accepted accounting principle (GAAP) according to the International Financial Reporting Standards (IFRS). Furthermore, companies can use variations on the theme, such as EBIT (earnings before interest and taxes), EBITA (earnings before interest, taxes, and amortisation), EBITDAR (earnings before interest, taxes, depreciation, amortization, and restructuring or rent costs) – you get the picture

What to do with this alphabet soup?

In the end, earnings are still the best way to determine if a company is worthy of your investment. But there are other factors you need to look at as well to get a complete picture about a company’s performance. Reading an income statement can be confusing, especially with all these different calculations, so sometimes you should get help from a trusted expert before you commit your hard-earned money.