We see in practice that the terms EBIT and EBITDA are often used arbitrarily in SMEs. However, it is good to know what the difference is and how these terms can be manipulated when buying a business.
What is EBIT?
EBIT (earnings before interest and taxes), also referred to as operating profit after depreciation (equipment and goodwill). It measures earnings from normal operations. That is, revenue and costs incurred to achieve revenue (purchasing, personnel, rent, insurance, marketing, etc.). Financial results (interest payments or interest receipts) and taxes are excluded. This is because interest and taxes are not considered operating results because they are not directly related to costs you have to incur to achieve a certain revenue.
What is EBITDA?
EBITDA (earnings before interest, taxes, depreciation and amortization), the "earnings before interest, taxes, depreciation of tangible assets and amortization of goodwill. EBITDA is considered a measure of a company's cash-generating ability because, compared to EBIT, it also excludes depreciation and amortization (non-cash).
I understand that TMT (Technology, Media, Telecom) and capital-intensive businesses have a natural preference to emphasize EBITDA more than, say, the "old-fashioned" profit term. An example might be a cable company, which has high depreciation charges that greatly depress 'classic' profits.
The preference for EBITDA is then argued with the proposition that depreciation of fixed assets and goodwill are only accounting purposes, can be influenced by management (after all, the estimation of the economic life has a subjective character) and does not require cash expenses (anymore).
I would like to make a few comments on this though:
#1 First, businesses often do need to continue to invest. This cash out is not directly reflected in the income statement, which maneuvers an important cost item (via depreciation costs) out of the picture. These investments are often not optional but necessary to maintain market position. Those who do not invest run the risk of dropping out. Especially in the TMT sector where today's business models may be obsolete tomorrow. Therefore, in my opinion, depreciation on investments made is still an undeniable part of the bottom line!
#2 In addition, it is important not to compare apples to oranges. Some TMT businesses run all (development) costs through the income statement which reduces EBITDA. While there are also TMT businesses that (obligatorily) capitalize part of their development costs, resulting in a much more profitable EBITDA.
#3 Both EBIT and EBITDA leave out the existing financing structure by omitting the interest expenses. After all, the starting point is the optimal post-transaction financing structure. I think this is a valid argument if, for example, there is a strategic buyer with deep pockets. In SMEs, however, there are still many heavily financed MBO/ MBI transactions that are rigged with a NEWCO construction. The financing structure of target (the company) is then certainly relevant.#
#4 Even if EBIT is used as a starting point, you still have to pay attention. The correction of depreciation is only representative if there is an ideal complex. In other words, if annual depreciation equals replacement investment. However, what matters is not so much the past investments, but rather the future profitability and the investments needed for that.
View the average EBITDA multiples per sector from the
Brookz Takeover Barometer (H1-2020)
Conclusion
Due to the multiplicity of profit terms, businesses will often present the profit term that shows the best picture. Capital-intensive businesses with high depreciation and interest costs are thus more likely to choose EBITDA. As a banker, I prefer EBIT(-margin) rather than EBITDA(-margin ) because it makes businesses more comparable, in my opinion. After all, EBIT reflects all operating costs. So also the cost of using assets in the form of depreciation.
Nevertheless, it is advisable to always look beyond pure EBIT or EBITDA. Figures are only a reflection of what has taken place in the company. Therefore, assess all figures and the developments therein, especially in light of the business model and the business risks arising from it.
