An overview of EBITDA - Microsoft Excel Tutorial

- [Instructor] Okay, so now that our statement of cash flows is good to go, the next thing we need to do is build our EBITDA schedule. And so if I scroll up to our model, in the income statement here, the net income line, I see a note from the CFO. "Can you build the EBITDA schedule below?" The reason we need this is to help report the financial covenants to our lenders. And we're going to talk more about covenants later in the course. But the big picture is financial covenants are like a financial health check for the business. And calculating the EBITDA is a key part of calculating those covenants in that metric. So before we build out the schedule in our model, let's just zoom out for a minute, talk about what it is and why it exists. And so, EBITDA, you probably know the definition in your head. It's the earnings before the interest, taxes, depreciation, and amortization. But why do we have it, right? It's one thing to know it. It's another reason to know why. What we're trying to do here is normalize the operating cash flow, or the core profitability, of a company neutral of a couple things, meaning we're trying to strip out a few things. That would be the accounting decisions, the financing decisions, and the tax environment, right? So up top we've got the interest, the taxes, depreciation, amortization. We're trying to strip out that impact. Important thing to know about EBITDA, EBITDA is a non-GAAP metric, meaning it doesn't fit in any kind of accounting standard anywhere. And this is some of the reason that people have a pretty big gripe with it is because you can get carried away with what are called adjustments. We're going to skip a lot of the adjustments for this course 'cause it's not really an M&A scenario, but in M&A, EBITDA adjustments can get a little bit carried away. That's because of the non-GAAP nature of EBITDA. What it's used for? It's ultimately used for a basis of valuation. Businesses are often purchased on a multiple of their cash flow, and it's often used for the covenant calculations that we're going to be doing in this course. So that's what we're doing. We are normalizing the operating cash flow of the company, neutral of its accounting decisions, financing decisions, and tax environments. Let's just talk about each one quick. So the first one, depreciation amortization. This one is kind of the most straightforward in my mind because these are non-cash expenses that sit in the income statement and we're trying to get a normalized operating cash flow. So these are added back to our net income to help calculate that operating cash flow. And what it does is it neutralizes the impact of the accounting policies of the company which could change based on their investment decisions or their accounting practices. So we strip that out because again, it's non-cash and the accounting policies can change company to company. So the next one is interest. This one a little bit tougher to understand than the accounting, but simpler than tax. Interest is part of the capital structure, which means how has the company been financed? It could be financed with all equity, it could be financed with mostly debt, or some kind of combo of debt and equity. And so if it was purchased with all equity, that means it wouldn't have any interest. But if you bring debt into the company, it has an interest expense. So the interest expense only exists to the extent the company has some debt on it. And so we add back the interest expense because it neutralizes the impact of this capital structure. In other words, we're showing what it looks like if the company was all equity owned. Then lastly, taxes. Why do we add back taxes, right? And in my head, this always confuses me a little bit 'cause I say, "Well, we have to pay taxes, right?" But the truth is, tax is subject to the entity structure of the company and the tax environment. And so specifically speaking, a C corporation, or people call a C corp, has a corporate income tax expense on its books. And that is the model that we're building here. We're going to pretend that this is a C corporation with an income tax expense. However, there are a bunch of other legal entities out there called pass through entities like S-Corps, LLCs, partnerships, and sole proprietorships. These entities have the taxes, what's called pass through the company to the members who own that company. And so they would take the tax burden of the business. And so you could see here, depending on the entity structure you may or may not have that tax expense. And so by adding back the taxes we are now neutralizing the impact of the entity structure and the tax environment. And now this one always confuses me 'cause again, you still want to try to create some kind of reserve for tax distributions for these pass through entities, but it is not an expense that hits the income statement like it would for a C corporation. So now that we've got the overview, in the next video it's going to make more sense as we start to model it out. But the big picture, if I'm just going to go back really quick, we are trying to normalize the operating cash flow or core profitability of this company, neutral of its accounting decisions, financing decisions, and tax environment so that it's comparable to other companies in an M&A scenario or for calculating covenants, which is what we're going to be doing in this course.