| Welcome to the Finance Storyteller series. I'm here to make business strategy and finance enjoyable and easier to understand. In this video we're going to cover the financial terms EBIT and EBITDA. Let me give you some context so that you know where EBIT and EBITDA fit in. There are three financial statements. The balance sheet and overview of what we own and what we owe at a point in time. The income statement and overview of the profit or income jet you generate during a period. And the cash flow statement and overview of how much cash you generate and where you spend your cash during a period. EBIT and EBITDA are income statement metrics. EBIT is earnings before interest and taxes. EBITDA is earnings before interest, taxes, depreciation and amortization. Earnings is the same as income or profit. The word before suggests that we're excluding certain items from our operational performance metric. Interest is excluded as it depends on your financing structure. How much did you borrow and at what interest rate? Taxes are excluded because it depends on the geographies that you work in. And the arbitration are sometimes excluded because they depend on the historical investment decisions that the company has made. Not the current operating performance. Let me show you an overview of an income statement or profit and loss statement so that you know where EBITDA and EBIT fit in. Revenue minus cost of sales equals gross profit. Gross profit minus SGNA and R&D equals EBITDA. EBITDA minus depreciation and amortization equals EBIT. EBIT minus interest and taxes equals net income. Please be aware that different companies use different terminology. So what you see here might be different from what your company is using. Also, not every company reports both on EBITDA as well as EBITDA. EBITDA is commonly used as a metric in very capital intensive industries like manufacturing, trucking, oil and gas and telecom. Service heavy industries like consultancy wouldn't even bother splitting out the two. What is depreciation and how does that work? Let's assume you want to buy a truck for your company to deliver your products. You spend $100,000 to buy it. What happens on your financial statements is that cash goes down by $100,000. Your fixed assets or plant and equipment go up by $100,000. It would be incorrect to book the full $100,000 straight away as a cost for the current year because you're going to use the truck for multiple years. That's when depreciation comes up. Let's assume that the truck has a useful economic life of five years and has no residual value. If you use straight line depreciation, you book 20,000 per year in depreciation. The value of the asset on the balance sheet goes down by 20,000 per year and in the income statement you charge this 20,000 as an expense. Let's look at an example of using EBITDA and EBITDA in financial reporting. I took the 2015 and a report of the Merch Group, a company headquartered in Denmark and operating globally. They report in US dollars. Their best known business is Merch line, which is the largest container shipping company. They are also active in areas like oil and gas, terminals and drilling. Merch's revenue in 2015 was 15% lower than the year before and the income or net profit was down by 82%. But as net income the most relevant way to measure their profitability performance, Merch gives you the choice to also evaluate profitability at other levels. EBITDA was down 68%, and EBITDA was down 24%. Depreciation and amortization are sometimes referred to as fixed costs. They don't go up and down with the number of units that you sell, but they are driven by the investments that you have made and the number of years that you use those assets. In the case of a company like Merch, which operates in a capital intensive industry, depreciation is a huge number, $8 billion in 2015, almost 20% of revenue. Looking at the EBITDA as well as the EBIT performance gives you more information than looking at EBITDA alone. What a business of finance people use EBITDA for is often mentioned as part of M&A or Merch's and Acquisitions news. The quick and dirty way to calculate the value of a company is by using a multiple of EBITDA. This can help you to get to a ballpark number, but I would advise to always do a more thorough analysis and a more thorough evaluation of a company as there are a lot of ifs connected to using an EBITDA multiple. You are assuming the profitability and the industry doesn't change, you exclude the impact of working capital, which could go up dramatically for a finance growing company, and you exclude the cash that you need for capital expenditures on an ongoing basis for the company. In summary, what is EBITDA? EBITDA is earnings before interest and taxes. EBITDA is earnings before interest, taxes, depreciation and amortization. Both EBITDA and EBITDA are measures of profitability along with terms like gross profit and net income. EBITDA is a meaningful metric for capital intensive industries. I hope you have enjoyed this finance storyteller video. Thank you for watching. Please let me know what you think in the comments section and connect on my blog, LinkedIn, Twitter or YouTube. |