EBIT or EBITDA? Or maybe EBIT?

EBIT or EBITDA? Or maybe EBIT?

Of course, EBIT . Next, EBITA . Simple and obvious.
But we also have many supporters of EBITDA . But why? The topic is a bit complex - we have the illusory power of EBITDA, the disadvantages of EBIT and a new quality, i.e. EBITA...

In order: EBIT is "Earnings Before Interest and Taxes" - earnings before interest (financial) costs and income tax; under the Polish Accounting Act, it is generally simply profit from operating activities. EBITDA is "Earnings Before Interest, Taxes, Depreciation and Amortization" - earnings before interest (financial) costs, income tax and depreciation. It is worth adding here that in the Polish financial nomenclature we have the term depreciation, which refers to both tangible and intangible assets. In English terminology, we have two different terms: "Depreciation" meaning (rather) depreciation of tangible fixed assets and "Amortisation" meaning (rather) depreciation of intangible assets.

It is very easy to see that there is a simple relationship: EBITDA = EBIT plus Depreciation.

The illusory power of EBITDA

Where is the false strength of EBITDA and the false weakness of EBIT? EBIT is to take into account all operating costs, including depreciation. While depreciation is an operating expense, it does not constitute a physical outflow of cash. For some analysts, EBITDA is more appropriate because it reflects the "monetary" side of operating profit, while EBIT including depreciation becomes less "monetary". The slogan "Cash is king" still rings true... But is it completely right?

Let the following simple example illustrate the lack of full EBITDA reliability.

Let's assume that we have two very similar companies A and B. Both companies generate sales revenues of PLN 55 million and costs excluding depreciation and financial costs of PLN 45 million. In both companies, the initial value of fixed assets (meaning amortized intangible assets and fixed assets) is PLN 15 million. The difference between the companies is that company A manages fixed assets better than B - A replaces assets on average every 5 years, while B is forced to replace assets every 3 years.
Of course, if we subtract costs excluding depreciation and financial costs from revenues, we will get EBITDA - PLN 10 million - i.e. both companies have the same EBITDA level. But what do cash flows look like? If the initial value of fixed assets is PLN 15 million, then A has an average annual investment expenditure of PLN 3 million (5-year period of reconstruction of fixed assets), and B incurs investment expenditure on average of PLN 5 million (3-year reconstruction period).

That is, cash flows in case A are on average 10-3 = PLN 7 million, while for B we have 10-5 = PLN 5 million. A big difference…

And what is the EBIT for individual companies? Assuming that we all know that depreciation is the cost of purchasing a given item of fixed asset spread over its economic useful life, the average depreciation for A is PLN 3 million. Where does this value come from? If PLN 15 million is the initial cost of purchasing fixed assets and we recreate them after five years, the depreciation is on average PLN 3 million (to put it simply, we mean linear depreciation with a zero final value of the asset). Similarly, for B, the average depreciation is PLN 5 million.
That is, in the case of A, EBIT would amount to an average of 10-3 = PLN 7 million, and B would generate EBIT of PLN 5 million. Please note that EBIT is exactly at the level of cash flows estimated earlier.

How to call EBIT in this situation? One might be tempted to assume that EBIT estimates normalized (average) free cash flow taking into account capital expenditures. What is EBITDA? This is only cash flow without taking into account investments in fixed assets. In order to exist and develop, every business invests in fixed assets. This means that assessing a company solely on the basis of EBITDA - without the necessary average capital expenditure - may be highly incomplete.

And this is exactly what happens in our simple example. EBITDA for both companies is at the same level, but the average EBIT, taking into account the significant difference in the management of fixed assets, is significantly different - A will generate EBIT 40% higher than B.

To sum up, EBITDA ignores the level of investment outlays, which may differ significantly for different entities due to, for example, objective conditions of operating activities as well as the method of managing fixed assets.

Is this the full picture? Not necessarily.

Disadvantages of EBIT

The key point for EBITDA supporters is that depreciation does not always actually reflect the economic useful life of fixed assets. There are two issues here.

The first issue is separate but interpenetrating tax and legal entities. Tax depreciation is intended to determine the tax base - for understandable reasons, companies apply the maximum allowed tax depreciation rates. Accounting depreciation should reflect the expected useful life of the asset and does not necessarily have to be consistent with tax depreciation. Companies are reluctant to use "double depreciation" - once for tax purposes, once for accounting purposes. This often means that depreciation rates - maximum in tax terms - are also used for accounting purposes and actually, on the one hand, overstate the depreciation cost and, on the other hand, understate EBIT (operating profit). In such a situation, the level of EBIT generated by a given entity may have limited cognitive value.

The second issue concerns intangible assets. Well... the issue of amortization of intangible assets is a real Pandora's box and I would not really like to be crushed by "this" Pandora... Generally, the level of amortization of intangible assets between "really" similar entities may be incomparable. The most important factors leading to such potential incomparability are:

  • different standards for preparing financial statements - for example, the Polish Accounting Act (hereinafter referred to as "AA") versus IAS/IFRS (international accounting standards/international financial reporting standards); as a detailed example, consider goodwill arising from the acquisition of an organized part of an enterprise - according to the Act on Business Act it is depreciated, according to IAS/IFRS it is not amortized and is only subject to annual impairment tests;
  • different accounting policies within the same accounting standards - for example, in the AA regime, different entities may adopt different economic useful lives for the same item of intangible assets (e.g. an acquired trademark), which will result in different amounts of depreciation write-offs;
  • various development strategies of the entity: organic growth versus growth through acquisitions - organic growth will favor the creation of its own intangible assets (such as goodwill, brand name, trademarks, etc.), intangible and legal assets created by a given entity (not acquired). legal entities are generally not subject to disclosure in the balance sheet and, consequently, are not subject to depreciation; acquisition growth may lead to the recognition of various items of intangible assets of the acquired entities (enterprises) in the balance sheet of acquired items (goodwill, trademarks, customer relations, etc.); subsequently, these recognized intangible assets may be subject to amortization.

Let there be EBITA...

Taking into account the fundamental problem with the comparability of amortization of intangible assets, apart from EBIT and EBITDA, there is also a third analyzed category of profit - EBITA: Earnings Before Interest Taxes and Amortization. EBITA stands conceptually as if in the middle of EBIT and EBITDA - we take into account the depreciation of tangible fixed assets, but ignore the depreciation of intangible assets. This profit category is based on the implicit assumption that the depreciation of property, plant and equipment is less discretionary and, as a result, more comparable - unlike the depreciation of intangible assets.

Other components of cash flow

Apart from the considerations on the lack of reliability of depreciation costs, for the sake of financial fairness, it should be mentioned that we also have other components of free cash flow. First, income tax: assuming that depreciation is entirely a tax expense (which is not always true) and that we have a CIT rate of 19%, income tax in our example would be PLN 1.33 million (19%x7) and 0.95 PLN million (19%x5) for A and B, respectively. So, taking into account the cash outflow from CIT, the cash flow for A and B would be PLN 5.67 million and PLN 4.05 million, respectively - still a difference of 40%. The second component not yet considered is the change in working capital. By not introducing this item into the analysis, we implicitly assume that we are dealing with a constant level of working capital, which, especially for growing businesses, is not necessarily true. The same is true in the case of the difference between capital expenditures and depreciation - for growing businesses, capital expenditures generally exceed depreciation, which of course means that free cash flow will be correspondingly reduced by the positive difference between capital expenditures and depreciation.

What conclusions?

If we were convinced that depreciation costs were "perfectly" estimated, then the advantage of EBIT over EBITDA is indisputable. Unfortunately, we almost never have such a belief. The solution is to analyze both profit categories: EBIT and EBITDA. Additionally, when the depreciation of intangible assets constitutes a significant part of the entire depreciation cost, it is worth performing an EBITA analysis. 

The above conclusion translates into the process of valuing enterprises using a comparative approach. Analysts often focus on the MVIC / EBITDA (MVIC - Market Value of Invested Capital) multiple and actually ignore MVIC / EBIT. This approach seems to be inappropriate - it is worth calculating both ratios: MVIC / EBITDA and MVIC / EBIT. It may happen that the value estimates for both multipliers will give significantly different values.


Value Solutions

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Cann Advisory sp. z o.o.
Plac Jana Henryka Dąbrowskiego 1
00-057 Warsaw
phone +48 22 616 20 32
mob. +48 606 234 150