Your money: Look beyond Ebitda to assess a company | The Financial Express

Your money: Look beyond Ebitda to assess a company

Ebitda tells how a business performs over a period of time. However, it does not accurately measure a firm’s liquid assets and revenue.

Your money: Look beyond Ebitda to assess a company
The Ebitda coverage ratio is calculated as Ebitda divided by the sum of principal and interest payments.

For investors, Ebitda (earnings before interest tax depreciation and amortisation) is one of the most widely used metrics as it provides a clear view regarding the core operating performance of a firm instead of focusing on the bottom line, i.e., net profit after tax. Further, it helps the investors to value firms by comparing their operating profit. However, depending on this metric alone could overstate a firm’s true performance as it is not a proxy for cash flow and thus lead to dubious valuation. Instead, investors could use the following allied metrics in addition to Ebitda.

Ebitda margin

A company’s Ebitda margin is defined as the percentage of calculated Ebitda in relation to its overall revenue. The goal is to figure out how much a company makes in cash profit. When a company’s Ebitda margin is higher than other companies, it means the company has more growth potential.

Also read: Guaranteed Return Plans vs FD, RD, PPF: Which is better for you?

Ebitda coverage ratio

The Ebitda coverage ratio is calculated as Ebitda divided by the sum of principal and interest payments. An outcome of one or more indicates that the firm has a better chance of paying off its debt obligations. Ebitda coverage ratio is an independent measure of a company’s performance because it does not compare companies.

Adjusted Ebitda

Adjusted Ebitda is arrived at by deducting the costs associated with one-time, irregular, and non-recurring expenses like litigation expenditure, forex loss, ESOPs etc., that have no bearing on a firm’s day-to-day operations. Adjusted EBITDA standardises a firm’s income and expenses (which varies across firms and industries). By normalising the income, cash flows and eliminating the outliers, adjusted EBITDA makes it easier for the investor to assess businesses’ performance irrespective of their differences.

Also read: Kotak Mahindra Bank Credit Card, Debit Card user? Here’s a chance to experience KBC 14

Drawbacks of Ebitda

The potential flop in the calculation of Ebitda is the exclusion of capital expenditure and its components. Another shortcoming is that when taxes and interest are added back to earnings, Ebitda ignores the cost of debt. As a result, Ebitda is prone to manipulation and allows companies to conceal problem areas in their financial statements by ignoring expenditures. Thus, a company’s performance risks can be hidden.

To conclude, Ebitda could be used to determine how a business performs over a period of time. However, it does not provide an accurate reflection of a company’s liquid assets and revenue.

P Saravanan is a professor of finance & accounting at IIM Tiruchirappalli. With inputs form A. Paul Williams, research staff at IIM Tiruchirappalli

Get live Share Market updates and latest India News and business news on Financial Express. Download Financial Express App for latest business news.