EBITDA is an acronym for earnings before interest, tax, depreciation and amortization. Investors, owners, business managers need to understand profitability. While it may be possible to understand profitability for a business, they would also like to benchmark against trends, other companies in the same industry, different geographical areas etc. Each company is structured differently. This makes profitability ratios difficult to compare. To enable comparisons, therefore, EBITDA has evolved. Each business structure may be different. Let us see what impact these differences will have on the profitability.
The capital invested in any two businesses may not be the same. Some businesses have more owned capital and others may have more of debt. Interest is paid on debt. So while one business may not have interest expense, the other might have interest expense. This has nothing to do with profitability from operations. The interest expense is eliminated to enable a fair comparison.
The tax structure of any two businesses may not be the same. The tax structure depends on a number of factors such as the ownership structure, geographical location, incentives provided by various levels of the government for different businesses. A fair comparison may not take place unless impact of all these items is eliminated.
Each business may also have different levels of automation. Automation requires more of capital expenditure that will also require a higher level of depreciation expense. The age of the business also determines the depreciation expense. Older capital equipment might have a lower level of spend and therefore lower depreciation. There are various intangibles that a company may have on its Balance sheet such a goodwill etc. Goodwill needs to be estimated and amortized once a year. This might result in swings in profitability between different companies and also between different years for the same business.
Therefore, while comparing profitability, it makes sense to eliminate the impact of these items that could be due to a non – operational reason. EBITDA serves his purpose.
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