The Comprehensive Guide on How to Read a Financial Report: Wringing Vital Signs Out of the Numbers, + Website

CHAPTER 20

WHAT IS EBITDA AND WHY IS IT IMPORTANT?

EBITDA—An Alternative View of Cash Flow or Operating Income?

One of the most commonly referenced terms and relied on financial reference points used by financial and accounting types is the ever popular EBITDA or earnings before interest, taxes, depreciation, and amortization. EBITDA has been around for decades but gained a significant amount of interest and use back in the 1980s during a period when leveraged buyout strategies were utilized to purchase companies.

What the buyers and their financing sources really needed to understand was how much EBITDA (or in their mind organic or internal cash flow) a company could generate to support future debt service payments. For example, if a company generated $10 million a year in EBITDA and the debt service requirements associated with the leveraged buyout was $6 million per year, then more comfort was gained that the company could adequately make the annual payment of $6 million (with some room to spare).

But let’s look a little closer at this all important metric and its relation to “cash flow.” You frequently see cash flow mentioned in the business and financial press. In reading news items and articles, often it’s not clear what the reporter means by the term cash flow. Reporters usually don’t offer definitions of the term as they are using it. When they do define cash flow, they don’t necessarily mean the amount in the statement of cash flows called cash flow from operating activities ...