Question

1) What is EBITDA? Why, if at all, is EBITDA potentially a better measure of financial strength than net income? What is total net operating capital? What are its principal components?

Answer 1

EBITDA means Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA). It is basically a measure of Earnings that are earned by the Firm before charging any Tax, Interest or Depreciation and Amortisation. It has special significance in comparison to Net Income because, while evaluating the earning potentials of the Firm, the fixed charges of interest which are solely attributable to the debtholders and not the entire sources of Finance (i.e. equity/common, preference and debt).Hence, to arrive at the non-biased earnings attributable to the entire firm, the charge of interest expense in excluded. Also since, tax is an unavoidable fixed charge on th earnings which is required to be paid inrrespective on income earned irrespective of the source, the same is excluded. Further, expenses like depreciation and amortisation are essentially notional in nature, without having any impact on the real cash outflow of the Firm. Thus the same are excluded as they do not impact the cash generating capacity of the Firm in the future. The only cash impact of Interest, Depreciation and Amortiisation is the savings offerred by them in calculation of tax, which would get saved when they would be charged. But since the tax expense in itself is spared, the impact of these also gets nullified.

Total Net Operating Capital essentially means that Capital that is invested into the Operations of the Firm. Implying that the funds, irrespective of the source they come from, which are utlisied in the Principal revenue producing activities of the Firm are termed as Total Net Operating Capital. It does not include Capital which is invested outside the business of the Firm for and withe intention of earning capital appreciations/ idle income on such investments (like interest, dividend, royalty, commission etc) and also any components in the Statement of Position indicating any accumulated losses or heavy expenditures not written off. As a corollary, it can also be said to mean the Amount of Operating Current & Non-Current Assets available with the Firm over and above its Operating Current Liabilities.

Total Net Operating Capital = Operating Non Current Assets + (Operating Current Assets - Operating Current Liabilities)