By MarketsFool.com

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.


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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.

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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.

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

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.

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