Measuring Earnings: EBITDA vs EBIT

The problem with any measure from the P&L statement (such as EBITDA, EBIT and NPAT) is that they rarely represent cash flow. Cash flow is important because we like to understand returns from a cash, rather than paper, perspective. However, measuring maintainable cash flow from the financial statements can be inaccurate and difficult, especially with public companies. Therefore, we’re often relegated to using P&L measures.

With this in mind, the major problem with EBITDA is that it has no provision for capital expenditure. Capex is a major cash item that doesn’t make it onto the P&L statement because capital assets are capitalized to the balance sheet. Some capital-intensive companies have huge capex, so knowing that EBITDA is $10m may be inconsequential. That company’s capital spend to maintain its business could be $9m, leaving cash of only around $1m (all else being equal).

The advantage of EBIT over EBITDA is that it somewhat accounts for capex through depreciation. This depreciation figure often represents a smotthed measure of capex since it accounts for items purchased over many years. So, in short, EBIT is a much better measure of long term maintainable earnings, even if still a little inaccurate. These other inaccuracies come from various deviations between cash and accrual accounting.

For most companies, the disconnect between EBITDA and actual cash flow is too wide to be of any real use on its own. The only exception I can imagine is using EBITDA in the analysis of business within the same industry where capex to revenue ratios should be similar across companies. In those cases, it is more feasible to use EBITDA, but still not ideal.

That said, EBITDA is still the average private equiteer’s favorite word and underpins how private equity values businesses. But you’d do well to remember that EBITDA alone does not tell you enough.


Due Diligence, EBITDA

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