5 Simple uses of EBITA by Analyst for Business

Earning before Interest tax and amortisation is often considered the surrogate for a business’s real profit.  Yes, you heard it right!

Moreover, EBITA can be used in multiple ways along with other line items like Revenue and company valuation to make meaningful judgements about the business quality.

Key Takeaways

1: EBITDA or EBITA is the proxy for real operating profit of business

2: Strong EBITA ofa company indicates pricing power

3:EBITDA can be used to compare investment oppotunties

Table of Contents

What is EBITA

EBITA  is a measure of company profitability, and it stands for Earnings Before Interest, Taxes, and Amortization.

However, that’s a theoretical explanation or, instead, definition but let me explain this most simply.

Now, Imagine for a sec that you are running a shop 7 Eleven

  • You sell 1000 items per day at an average price of $5.
  • So the total Revenue is $5000

Now revenue, as you can see, tells very less about how well we run the business. Hence the next step is to reduce the costs.

  • Firstly, Let’s suppose that the average price of these products was $3, so total direct costs = $3000
  • Now Revenue – Direct Costs = $2000 Or the gross profit.
  • However, you also have salaries and rent to pay and let’s say that’s $1000.
  • So, gross profit- indirect expenses= EBITDA or $2000 – $1000 =$1000

So to sum it up, It is helpful to compare one company to another in the same line of business.

Also, In some cases, it can provide a more accurate view of the company’s actual performance.

Firstly, Investors use EBITA as an indicator to measure the efficiency of specific companies and compare them with other similar companies.

Also, EBITA includes the cost of capital assets (depreciation) but excludes the financing costs and the amortization of any intangible assets.

As a result, it can measure the performance of companies more accurately.

Importance of EBITA

From the previous example, if I ask you a simple question. First, What’s more critical, Higher EBITDA or Higher Revenue?

  • Firstly, higher revenue is not indicative of greater profitability, whereas higher EBITDA would mean that your margins are good.
  • Secondly, higher EBITDA margins also mean that you can sustain business shocks. Like the temporary increase in the cost of goods or maybe higher some extra people.

Example: Lead Prices & Battery Manufacturers

Now, Let me explain this with a live real example. In the battery manufacturing business, the main cost is the cost of Lead.

Prices of lead since 2014

Now, imagine a company like Exide industries, which manufactures lead batteries for cars.

However, If their margins are not good, such price fluctuations can lead to tremendous business shocks or even shutdowns.

Amaraja Battery EBITDA Margins

Highest EBITDA Margin Business in India

Certificate in Investment Banking

Now, the above image shows that, generally service industry will have higher EBITDA Margins.

Also, You may ask why? Well, because a service industry like Information technology has no cost of goods but the cost of service.

Whereas a manufacturing industry will have costs of goods plus salaries to pay. Now,I came across this very nice image, which shows margins across various industries

source: FT Times

However, It’s funny to see that no wonder people pay so much for real estate; it runs at 90% EBITDA margins.

How to Calculate EBITA

There are two methods by which one can calculate the EBITA. 

  • Direct Method:

Firstly, In this method, the cost of goods sold (COGS) and operating expenses less amortization are subtracted from the company’s total revenue. 

EBITA = Total Revenue – COGS – (Operating Expenses – Amortization)

  • Indirect Method:

Secondly, In this method, the interest, taxes, and amortization are added back to the net income, giving the EBITA value.

EBITA = Net income + Interest + Taxes + Amortization

Also, Companies may not provide a breakdown of operating expenses of the cost of goods sold. In such scenarios, the indirect method can be used to calculate the company’s EBITA.

Example

Now, Let’s take a look at the income statement of Company ABC for 2018 and 2019:

For example;In 2018, the company had total revenue of $1,500,000 and a net income of $1,394,000. In 2019, total revenue increased to $1,700,000 and the net income fell to $1,359,000. Higher sales with smaller profits can be explained using EBITA. When the company’s net income is adjusted for taxes, interest, and amortization expenses, the profit instead increases. 

EBITA for 2018 = $1,394,000 + $6,000 + $35,000 + $0 = $1,435,000

EBITA for 2019 = $1,359,000 + $6,000 + $90,000 + $105,000 = $1,560,000

Now, The above calculation shows that even though the company’s net income decreased by $35,000, the earnings before interest taxes and amortization for the company increased by $125,000 in 2019.

5 Uses of EBITDA

Now, Let’s discuss five ways in which we could use EBITA.

  • Firstly to Filtering Companies: Calculate EBITDA/ Revenue to filter out profitable companies or decide on which business to enter.
  • Also, as an Indication of Product Quality: Look at the below data; there is a reason why AAPL margins because their products are amazing.
  • Thirdly, to Increase Efficiency: A company could analyse its costs to understand where the leakages are and fix them.
  • Also, an indication of an Increase in Capital Expenditure: A company could find ways to spend money on machines and automation, which could reduce operational expenses and increase EBITDA margins
  • Finally, Work on Scale: Generally, margins are lower initially in a business because the sales haven’t taken off, but sometimes, this can also be due to the product not being scalable at all. Which would mean that company cuts its losses on unscalable business or products and work on scalable ones.

Conclusion

I would suggest playing around with company data and understanding how different business work with different margins. Also, understand that EBITDA margins don’t necessarily mean cash. A company could have great EBITDA Margins with products sold on credit. Then what? All noise but no real cash.

ALLEN ARAVINDAN,CFA
ALLEN ARAVINDAN,CFA

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