Why Use EBITDA Instead Of Profit?

As I try to answer the question; “Why use EBITDA instead of profit”, I struggle to give a good answer, as to why to use EBITDA at all.

EBITDA is earnings before interest, tax, depreciation and amortisation, and is often used to value small businesses. Some argue that EBITDA represents a better picture of profit from trade operations, but by adding back depreciation and amortisation, this distorts the profitability of the business.

EBITDA is often used by investors, business brokers and the like, to value a business, but using EBITDA for business valuation purposes is flawed.

Is EBITDA flawed?

EBITDA is flawed, as a metric for valuing a business, because it ignores depreciation and amortisation, as if these are not genuine costs to the business.

This simply isn’t the case.

It’s true that depression and amortisation are both non-cash entries in the profit and loss of a business, but that’s no different to an accrual for a cost, where the bill is received in the following month. But you don’t add-back accruals to adjust the profit for business valuation purposes because they are non-cash, so why add-back depression?

This makes no sense to me.

Depreciation is a delayed cash entry

Depreciation is effectively a delayed cash entry, because although depreciation is a provision to write down an asset the business already owns, which is done over its useful economic life, you should also look at depreciation as a provision for replacing that same asset in the future.

Which means, if depreciation is removed from the profit figure, which is what happens when EBITDA is calculated, you are not taking account of what these assets represent, as a cost to the business from one year to the next.

For example, in simple terms, if you buy a piece of factory equipment for £10,000, which has an economic useful life of say 5 years, this assets will be depreciated at a straight line rate of 20% per year, or £2,000 each year. But remember, if this asset has a useful life of 5 years, that means it will need to be replaced in 5 years once again.

If the £2,000 is added back to adjust the profits by this amount, the resulting EBITDA figure, if used for valuing the business, will overstate its value.

For example, if you use the multiplier method to value the business, and let’s say the multiplier you have chosen for the business is let’s say 3-times adjusted profits, if EBITDA is used, the business will be over valued by £6,000 (I.e. 3 x £2,000).

Now, you might say, £6,000 isn’t much, but this was just an example. Where this becomes a big over-valuation problem is when you have a business which is heavily capitalised.

This happened to me when I was in the process of buying a business. One such business I came across was a transport business, which had expensive lorries on the balance sheet, and this same company had high amounts of depreciation on the lorries charged to the profit and loss.

I found this business through a business broker, who had valued the business using EBITDA, and they had added back depreciation in their valuation calculations.

This meant that the business was hugely overpriced, but unfortunately the broker didn’t agree, and more importantly, neither did the owner agree. Needless to say, I walked away from the deal and I didn’t buy this business.

So, coming back to the question of this video, which is; Why use EBITDA instead of profit, I can’t see a good reason for using it.

EBITDA is used to compare similar businesses

Some say it’s a good method to compare one similar business to the next, but even this doesn’t really make sense to me either.

Depreciation calculations are governed by accounting rules, which means that most businesses will use similar rates for similar assets. If an asset has a useful life of X years for one business, in theory it has the same useful life in another.

I understand the other add backs of EBITDA, which are interest and tax, because every business will finance the business in different ways.

Some businesses are financed using loans, and therefore there will be an interest charge in the profit and loss, whereas other businesses won’t, so there won’t be an interest charge.

So by stripping out the interest in the business that’s financed using loans, this will help when trying to compare it to the one that doesn’t have any loans.

A similar argument applies to interest income, as the “interest“ in EBITDA refers to interest paid and interest received.

Some businesses may have better cash flow that others, and they may be better at setting aside cash that is deposited in interest bearing accounts, whereas other may not be able to do the same if they don’t have good cash flow and cash to invest in this way.

So, by stripping out interest income from the business that has it, versus the business that doesn’t, means these companies are easier to compare.

Finally, it also makes sense to strip out tax paid from one company to another, as taxes can be quite legitimately manipulated in a manner of ways from one company to another, which means to compare one company to another, this makes it easier to do so.

Some people say that EBITDA shows income before non-cash expenses, but even this isn’t the case, as interest (both paid and received) and taxes are cash expenses or income, actually paid and received. I accept that depreciation and amortisation are non-cash items, but I covered this at the start of this article.

I am open to suggestions as to why EBITDA is used instead of profit, but for now I’m not convinced EBITDA stands for anything useful.

I’ve mentioned about EBITDA and business valuation, and suggested this shouldn’t be used to value a business, so if you would like to know what profit to use to value a business, I suggest you watch the on this article: How to value a small business.

If you have any questions on this topic, or on any other aspect about business, please drop a comment below.

And always remember that no question is a stupid question, if you don’t know it, you don’t know it.