Are you looking to conduct a comprehensive fundamental analysis and select top-performing companies for your investment portfolio? Learning the popular financial metric “adjusted EBITDA” can certainly help you! Understand this concept and use it to evaluate a company's operational performance. Let us begin.
What is EBITDA
EBITDA stands for Earnings before Interest, Taxes, Depreciation, and Amortisation. It represents a company's earnings before considering the impact of non-operating expenses such as:
- Interest
- Taxes
- Depreciation, and
- Amortisation
EBITDA shows a company’s ability to generate profits from its core business activities.
What is adjusted EBITDA
An adjusted EBITDA is obtained from EBITDA by further adjusting for non-recurring or non-operating items. These adjustments often include:
- One-time expenses
- Restructuring costs
- Gains or losses from the sale of assets, and
- Other extraordinary items
By excluding these items, adjusted EBITDA provides a clearer view of a company's ongoing operational profitability.
What is the key difference between EBITDA and adjusted EBITDA
The primary difference lies in the adjustments made to the earnings figure. Read the table below:
| Additions of EBITDA | Additions of adjusted EBITDA |
| Interest, taxes, depreciation, and amortisation | Interest, taxes, depreciation, and amortisation+Non-operating or non-recurring items |
How to calculate adjusted EBITDA
Most financiers first calculate EBITDA and then make the necessary adjustments to obtain adjusted EBITDA. Let us do the same and understand the calculation:
Formula: EBITDA = Net Profit + Interest Expense + Income Tax + Depreciation + Amortisation
- You start with the net profit and then add back:
- Interest expense
- Income tax
- Depreciation and
- Amortisation expenses
- Interest expense and income tax are added because they are financial costs and are not directly related to the core operating activities of the business.
- Whereas depreciation and amortisation expenses are non-cash charges, meaning they do not directly impact the company's cash flow.
Let us understand better using a hypothetical example:
ABC Ltd. is in the business of providing software services. It reported the following financial figures for the year ended 31.03.2024.
- Net profit: Rs. 15,00,000
- Interest expense: Rs. 2,00,000
- Income tax: Rs. 4,00,000
- Depreciation: Rs. 3,00,000
- Amortisation: Rs. 1,00,000
Using the formula discussed, we can calculate EBITDA as follows:
EBITDA = Net Profit + Interest Expense + Income Tax + Depreciation + amortisation
EBITDA = 15,00,000 + 2,00,000 + 4,00,000 + 3,00,000 + 1,00,000
EBITDA = 25,00,000
We can observe that the EBITDA for ABC Ltd. for the year ended 31.03.2024 is Rs. 25,00,000. An interpretation of this figure provides insights into its operational performance.
Calculating adjusted EBITDA
Formula: Adjusted EBITDA = EBITDA + Other Adjustments
Several additional items are added to EBITDA to arrive at adjusted EBITDA. These items are commonly categorised into:
- One-time expenses
- Non-recurring income
- Restructuring costs
- Gains or losses from the sale of assets, and
- Other extraordinary items
Let us extend the above example and calculate the adjusted EBITDA for "ABC Ltd." by considering these additional adjustments:
In addition to the figures provided earlier, the company incurred the following expenses during the year ended 31.03.2024:
- Stock-based compensation expenses: Rs. 1,50,000
- Restructuring charges: Rs. 1,00,000
To calculate adjusted EBITDA, we need to add these adjustments to the EBITDA figure we obtained earlier.
Adjusted EBITDA = EBITDA + Other Adjustments
Adjusted EBITDA = 25,00,000 + 1,50,000 + 1,00,000
Adjusted EBITDA = 27,50,000
We can observe that the adjusted EBITDA for ABC Ltd. for the year ended 31.03.2024 is Rs. 27,50,000. This figure provides a more accurate representation of the company's operational performance by excluding certain one-time or non-cash expenses.
The three common do-nots to avoid during calculation
- Do not miss any adjustment
- You must thoroughly review financial statements and disclosures to ensure that all relevant adjustments are accounted for.
- Do not misclassify expenses
- Carefully categorise expenses to determine whether they should be included as adjustments or not.
- Do not overlook non-operating income
- In addition to expenses, you must consider all the non-operating incomes that need to be adjusted.
- In addition to expenses, you must consider all the non-operating incomes that need to be adjusted.
What does adjusted EBITDA tell you?
It offers a clearer view of the core earnings generated by the company's day-to-day business activities. This view allows investors and stakeholders to assess its ongoing performance more accurately.
Let us see the three most common interpretations you can make:
| Interpretations | Explanation |
| Operational performance | You can evaluate a company's operational efficiency and its ability to generate profits from core business operations. |
| Strength of fundamentals | You can compare and identify companies with strong operational fundamentals and sustainable earnings power. |
| Debt servicing capacity | You can assess a company's ability to service debt obligations and determine the company's:
|
Can you completely rely on adjusted EBITDA?
It should be used judiciously and with other financial metrics to obtain a well-rounded view of a company's financial health. Let us see some of its common limitations:
Exclusion of certain expenses
- Adjusted EBITDA excludes certain expenses, such as interest, taxes, depreciation, and amortisation, as well as other adjustments.
- While this provides a clearer view of operational profitability, it may also mask underlying financial weaknesses or inefficiencies.
Subjectivity of adjustments
- The determination of adjustments in adjusted EBITDA can be subjective and may vary between companies or analysts.
- This introduces a level of subjectivity and potential inconsistency in its interpretation.
Does not reflect the cash flow
- It does not directly reflect cash flow, as it excludes certain cash expenses such as interest and taxes.
What other financial metrics can you use
You can complement adjusted EBITDA with several other financial indicators to obtain a comprehensive assessment of a company's performance. Let us see the key metrics:
| Metric | Meaning | Use |
| EBIT (Earnings Before Interest and Taxes) | EBIT is similar to EBITDA but excludes depreciation and amortisation. | It provides a measure of a company's profitability before accounting for non-operating expenses such as depreciation and amortisation. |
| Free Cash Flow (FCF) | FCF represents the cash generated by a company's operations after accounting for capital expenditures. | It indicates the amount of cash available for:
|
| Debt-to-Equity ratio | This ratio compares a company's total debt to its shareholders' equity. | It shows a company's capital structure and financial risk. |
Conclusion
By analysing adjusted EBITDA, you can obtain a clear picture of the company's operational profitability by excluding certain non-recurring or non-operating items. It offers a simplified view of a company's financial health and helps in making informed investment decisions.
To begin with, you must first calculate EBITDA using the net profit and then make the necessary adjustments to obtain adjusted EBITDA. You can use it to understand the strength of the core business of the company.
However, owing to several limitations, you must use it with other financial metrics.
