What Is EBITDA?

An acronym, EBITDA stands for earnings before interest, taxes, depreciation, and amortization, and is a useful metric for understanding a business's ability to generate cash flow for its owners and forjudging a company's operating performance.

Why EBITDA?

The benefit of using EBITDA to evaluate a company's performance is that it is capital structure neutral. Thus, it is not affected by decisions like how a company finances its balance sheet (debt or equity, or a mix of both). In addition, it also excludes non-cash expenses like depreciation, which may or may not reflect a company's ability to generate cash that it can pay back as a dividend to its owners.

Suppose you wanted to evaluate two lemonade stands. For the purposes of illustration, we'll assume these two companies use the exact same lemonade stands and carry the same amount of inventory, cash in the register, etc., thus their balance sheets carry the same amount of assets.

Lemonade Stand A was funded entirely by equity. Lemonade Stand B primarily uses debt to fund its operations. The only difference between them is how they choose to finance these assets -- one with debt, one with equity.

Income statements for these two lemonade stands appear below.

Lemonade Stand A
Revenue	$1,000
Cost of Goods Sold	$200
Interest Expense	$0
Depreciation of Lemonade Stand	$50
Income before taxes	$750
Net income (35% tax rate)	$487.50
EBITDA	$800

Lemonade Stand A

Revenue

$1,000

Cost of Goods Sold

$200

Interest Expense

Depreciation of Lemonade Stand

$50

Income before taxes

$750

Net income (35% tax rate)

$487.50

EBITDA

$800

Note that Lemonade Stand A earned $487.50 in net income, while EBITDA was $800 in the example year above.

Lemonade Stand B
Revenue	$1,000
Cost of Goods Sold	$200
Interest Expense ($1,500 at 10% interest)	$150
Depreciation of Lemonade Stand	$50
Income before taxes	$600
Net income (35% tax rate)	$390
EBITDA	$800

Lemonade Stand B

Revenue

$1,000

Cost of Goods Sold

$200

Interest Expense ($1,500 at 10% interest)

$150

Depreciation of Lemonade Stand

$50

Income before taxes

$600

Net income (35% tax rate)

$390

EBITDA

$800

Because Lemonade Stand B uses substantially more debt ($1,500 at 10% interest) to finance its operations, it is less profitable in terms of net income ($390 in profits versus $487.50). However, when compared on the basis of EBITDA, the lemonade stands are equal, each producing $800 in EBITDA from $1,000 in sales last year.

If you had to decide which lemonade stand to buy, you might think Lemonade Stand A is the better investment because it has higher net income. However, in reality, these companies are equal; Lemonade Stand B simply employed more debt than equity, and thus had more interest expense dragging on its net income.

When a company is sold, it is typically delivered to the buyer debt-free. Thus, the differences in how these businesses currently finance their assets is not at all important to a new owner, who can choose how he or she would prefer to finance the business. This is why using EBITDA as an earnings metric is very common in private equity or in mergers and acquisitions, where it is assumed that a new owner will have the ability to change the construction of a company's balance sheet.

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at knowledgecenter@fool.com. Thanks -- and Fool on!

The article What Is EBITDA? originally appeared on Fool.com.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.