Tim Bennett Explains: What is EBITDA?

in another video I look at the profit figures that investors can trust on the ones that I'd be a bit wary of made-up by management in this video I want to look at a number that features quite heavily in analyst reports ok the press also comment on it it's not one that you'll find in a set of statutory accounts but I would like to hand it for lists of quite useful numbers used in the right hands in the right sector is called a bit da it's a variation of the standard operating profit number and this video is all about where it comes from and why it's considered to be quite useful ok so here's a basic profit statement now without running through every part of it you've got the usual statutory headings signed off by the auditors you've got sales at the top you've got the gross profit line you've got the operating profit line also known by the way as EBIT earnings before interest and tax which gives you a clue as to where a bit Dharma come from in a moment then you've got your interest costs your tax bill and the result for the year all right now these two headings here gross profit and operating profit are useful and are widely used quite rightly by analysts journalists and so on alright gross profit is the heart of the business reflected in a profit number and a profit margin before overheads operating profit is basically the business activities ignoring finance costs which are simply a reflection of how the business is funded not how it trades and the tax bill which is a function of tax rules not really relevant to deciding how profitable the business is from its trading activities so there are good reasons to look at both the gross profit and gross profit margin operating profit an operating profit margin so what's a bit Darul about EBIT dar is about saying well actually yes this is an important number but it suffers it suffers from one floor and that is it is stated after a couple of quite subjective dodgy costs have been removed ones known as depreciation the others known as amortization so if we add those back or you strip out their effect we'll get to a profit figure that can be trusted a profit figure that is not influenced by a rather strange accounting quirk it's called a bit da now what is that accounting quirk well to create a bit dull first of all you start with the operating profit number now most you won't have to do this at home it's just to give you a flavors where it comes from and back the annual depreciation expense and add back the annual amortization charge hence EBIT da all right earnings before interest tax depreciation and amortization all right or earnings before dodgy items if you like now what is suspicious about depreciation just by the way depreciation is the term that we use in the UK for long term assets you can kick plant machinery and so on Pamela's Asian belong term assets that you can't so patents licenses and goodwill and so on what is it depreciation is the director's way of dealing with the cost of assets that are used year in year out in the business if you buy an asset for let's say a hundred thousand pounds rather than dumping that cost against year ones profit given the assets going to be used over maybe ten years here what the directors actually do is they knock off a proportion of the assets cost against profits each year how do they know what proportion to knock off will essentially they decide they decide how long the assets going to last they divide the original cost over that useful economic life as it's called and the result is depreciation so if you're looking at the asset Book value in the balance sheet you get a kind of steady drop off as in this case 10,000 pounds of depreciation is charged against each year's profit a loss account an analysts often don't like this because they say well who decides the ten years and no and therefore the 10,000 pounds why not 20 years which would have the depreciation expense why not five years we should double it and everything you do to depreciation you are doing to operating profit and therefore changing the way that the company presents its results so essentially because of some of these assumptions the directors have to make to arrive at depreciation or an amortization expense including how long the asset will last what it'll be worth when they finish with it in sales terms and even what method they're going to use alright to actually depreciate the asset or as you speculate life so this give you a flavor for that this isn't an accounting video but a flavor for that straight line has that sort of impact there is another method called reducing balance that basically applies a percentage to the book value of the asset the effect is to kind of create a almost a decline more like that if you like more depreciation in the earlier is less and in the later years the point is all the time changing the profit figure that's being recorded because of these things quite a few analysts like to say I will to complicate it don't like look at this it sounds dodgy sounds objective so let's take it out let's simply take it out it's going to do that by the way you can restate operating profit and then create something called an e bit d'argent so I'm going to finish by just looking at that there is my basic profit statement with the operating profit line in there what would I do to turn that into E bit goal well what I do is I go hunting around for a depreciation charge and a novelization charge there is a note to the accountant for those people interested that tells you what those amounts were here twenty five and twenty million respectively and I'd add them back easy for me to say so I take 120 and back twenty and back twenty five so E bit da is now 165 million by adding items back their previous been charged I'm increasing the number am a bit d'argent is 41% that is the a one six five as a percentage of sales and that is also higher than my existing growth operating profit margin 120 over 400 as a percentage all right now that's the basics of how i bitar is calculated is it a perfect number no don't go away from this video thinking brilliant now on I will always substitute operating profit for e bit R and here's the reason all right although this number does allow you to more easily compare perhaps industries with different levels of capital intensity alright some critics would say just be careful because you are looking at a profit number that yes might be a bit close to cash flow which is the main argument for it but also strips away some very important costs earnings before interest for example all right so you're not deducting interest on debt all right and you're also not deducting the depreciation of fixed assets so they paint you a picture here imagine you're trying to expand the telecoms firm really quickly you're buying loads of fixed assets to do so you're funding it all with debt so you're taking on balance sheet risks you're growing fast you're increasing balance you risk but top line sales are going up any bit dolls also going up and your remuneration is linked to EBIT doll marvelous but do we want to invest ultimately in companies that grow at any cost not necessarily I'll leave you with that thought quite a lot of ground covered there any questions or comments as usual please contact me at editor a killer calm you

Channel: Killik & Co

Views: 105,577

Keywords: EBITDA, What is profit?, depreciation, amorisation, shares, equity investing, how the stockmarket works, why buy shares?

Id: cbk2LJ22w90

Length: 8min 8sec (488 seconds)

Published: Wed May 28 2014