All public companies have to generate a series of financial statements for outside review. It is a good idea for all companies, even small businesses, to prepare these schedules.
Knowing how the business is doing on a regular basis can enable a company to make changes necessary for continued success.
One of the basic financial statements is the Income Statement, which measures the profit or loss of the company over a specific period of time. The standard format of the Income Statement is to subtract total expenses from revenues to arrive at income, or earnings.
Businesses break down expenses into different components. Operating expenses generally include supplies, salaries and other direct expenses. According to Investopedia.com, other important categories are:
- Depreciation: A method of allocating the cost of a tangible asset over its useful life. Businesses depreciate long-term assets for both tax and accounting purposes.
- Interest: The charge for the privilege of borrowing money, typically expressed as an annual percentage rate.
- Taxes, with which you are probably familiar.
- Amortization: The deduction of capital expenses over a specific period of time (usually over the asset’s life).
In addition to the standard measurement of income, a popular method of looking at a company’s financial health is to look at EBITDA, which is Earnings Before Interest, Taxes, Depreciation and Amortization.
An Example of EBITDA Analysis
One way to see how businesses use EBITDA is to look at two companies in a similar industry; we’ll call them companies A and B for simplicity. On the latest Income Statement, both companies have $100 million in revenue and $90 million in total expenses, resulting in net income (total earnings) of $10 million.
From first glance, you would think these companies are pretty similar. Assume now that for company A, depreciation expense is $20 million, and interest expense is $10 million. Company B has depreciation expense of $5 million and no interest expense. Neither has any tax or amortization expense.
Although both companies have net income of $10 million, company A has Earnings Before Interest, Taxes, Depreciation and Amortization of $40 million, while company B has EBITDA of $15 million.
Just driving a bit below the surface, we can see that company A appears to have a stronger financial position based on EBITDA. Company A is spending a lot less of its money on Operating Expenses ($50 million vs. $75 million.)
It is possible that Company A recently completed a large capital project, which increased its depreciation and interest, maybe with the benefit of decreased operating expenses. There are a number of other indicators that you can check to verify this, including the average age of capital ratio.
On a positive note, it does show that there may be opportunity for Company B. If B can benchmark with A (either by friendly communication or viewing their operations from a distance) they may be able to implement similar improvements. It will depend on their operational abilities and whether they have access to the kind of capital Company A did.
Whatever the reason, at first glance Company A’s superior EBITDA indicates a better financial position. Fully understanding the differences between the two companies requires additional analysis, but EBITDA is a great starting point.
EBITDA as Indicator of Financial Health
Businesses who utilize their EBITDA information will have a better understanding of the company’s true fiscal health; the EBITDA will also give you information which is useful when planning future changes in your company.