How and when should we use EBITDA and EBIT?
How to decide which one is better suited in a given situation?
Here are the four main usages of EBITDA and EBIT:
1) Peer group analysis
The biggest advantage of EBITDA and EBIT is their simplicity of calculation, meaning you can easily find the data and compare companies’ performance across a portfolio.
However, this simplicity has its disadvantages too. It is difficult to find two or more companies with exactly the same business model. Companies differ in many ways – market position, geographies they serve, capital intensity, asset structure, level of technological advancement…All of this makes true comparisons difficult.
When should we use EBITDA and when EBIT for peer group analysis?
It mostly depends on the company’s level of capital intensity.
EBIT is a better metric in capital-intensive industries (e.g., airports, airlines, hotels, energy…) because it better depicts the real, underlying cost structure needed to support the sales generation.
For example, under some accounting standards, operating leases are shown in Opex (SG&A). However, under IFRS, operating leases are shown in the depreciation and interest expense lines of the P&L, which makes comparison of companies applying different accounting standards at the EBIT level meaningless.
Another thing to watch out for are the depreciation policies because assets can be depreciated and amortized under different estimates of asset useful lives. For example, in one of my analyses of a domestic food retail sectors, it turned out that the 10 largest companies applied 7 different approaches to asset depreciation.
In most of other cases, comparison at the EBITDA level might be good enough.
2) Proxy for cash flow available for debt service
Both EBITDA and EBIT are derived from the income statement (P&L), hence they represent profitability metrics.
However, they are often used as a proxy for cash flow available for debt service.
That can be fine in some circumstances, but most often it’s not. That’s why there is a separate financial statement called the Cash flow statement ????.
Which one is a better proxy for cash flow available for debt service, EBITDA or EBIT?
Again, it depends on the industry a company operates in.
EBIT is a better metric for capital-intensive companies because depreciation and amortization serve as a proxy for Capex. It shows how much should a company spend to maintain its asset base, which in capital-intensive businesses is a core driver of sales.
However, EBITDA remains a prevailing metric. It is often quoted by management in their reports because EBITDA is normally a high number, and it can be manipulated. Banks use it too because of its simplicity. Even their rating methodologies accommodate the usage of EBITDA.
In any case, one has to be aware of EBITDA and EBIT drawbacks.
First, EBITDA and EBIT are not cash flow metrics. They merely represent how the operating result would look like if all revenues were collected and all expenses were paid.
Second, EBITDA and EBIT do not include essential and real expenses like interest and taxes. Not only they are real, but they are the top of the priority list.
Finally, EBITDA and EBIT may overstate or understate the companies’ performance in many industries, especially more cyclical ones. Working capital is a critical driver for many companies’ cash flow generation, and EBITDA and EBIT fail to capture those changes. These metrics are normally smoother than cash flow, and as a banker or analyst, you want to capture this volatility in your assessment.
Both EBITDA and EBIT should be used carefully, and always in conjunction with other ratios to get the whole picture of a company’s performance.
3) Financial covenants
EBITDA and EBIT are often used in lending agreements as financial covenants, most notably in the Leverage ratio (Net (Debt / EBITDA)) and in the Interest cover ratio (EBITDA or EBIT / Interest expense). In some instances, there is also a covenant which defines the minimum level of EBITDA or EBIT.
Taking into account previously mentioned disadvantages of EBITDA and EBIT, their quality as early warning signs is limited.
Most Interest cover ratios were meaningless during the period of low interest rates, but their importance might increase now when the interest rates are going up. However, the experience shows the Leverage ratio is triggered earlier than Interest cover ratio, so it is almost always better to aim for that covenant.
Which metric should be used in financial covenants, EBITDA or EBIT?
EBITDA is used more often because of its simplicity. It is very rare to see a loan agreement without EBITDA being used, even only as an incurrence covenant.
The most important thing is to pay attention to the definition / formula of the metric used, because there are numerous variations of EBITDA and EBIT possible. Please be reminded that these metrics are not defined by any accounting standards.
4) Executives’ remuneration
EBITDA or EBIT are often part of the executives’ bonus schemes.
This is less than ideal, because in practice it happens that the KPI set becomes the goal.
EBITDA and EBIT might not be the best financial targets in the long run, because a company has to cover all expenses (including interest and taxes), it has to invest to remain competitive, it might also need to pay out dividends, etc. All of this is not covered by either EBITDA or EBIT.
When defining proper KPIs for executives’ bonuses, it is important to be clear how the metrics are calculated and limit the space for arbitrary decisions like, for example, changing the depreciation policy.
Ideally, the bonus scheme includes more financial metrics, requiring executives to apply holistic approach in managing the business.
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