The Premises for This Computation:
Add: Income Tax Provision
Proponents of this concept merely expounded on the EBIT premises, in which the income tax for the reported earnings is technically ignored. Most creditors use EBIT since the amount of tax reflected is still arguable and subject to IRS assessments. See a separate article entitled How to Calculate EBIT for more details about this concept.
Add: Depreciation and Amortization Expenses
Under the EBITDA concept, the objective is to gauge the results of business operations on a purely cash basis. Depreciation and amortization expenses are mere valuation entries and represent the expense portion of a capitalized expenditure as a way of matching income and expenses.
Lenders may consider the borrower's argument that these are expenses that will not affect their future cash positions. The original accounting entries used to set up the capital expenditure had previously recognized the reduction in their cash as a past transaction. To consider it as future cash reductions creates a redundancy in reducing their liquidity. Hence this concept adds back depreciation and amortization expenses to the income, for purposes of determining a more realistic cash position.
Less: Interest Income on Deposits
That being the case, interest income earned on the borrower’s bank deposits is disregarded, inasmuch as it is also arguable as an addition to future cash positions. Interest income amounts are reliant on the amount of deposits; and should the bank grant a substantial loan, part of the future interest credits will be based on the loan proceeds, which will form part of the borrower’s deposit balance. Thus, past interest credits should be disregarded as well; hence, they are deducted from the present earnings.
However, the reader is reminded that creditors use this concept only for credit risk analysis and not for reportorial purposes, since the arguments and premises involved do not conform to SEC’s GAAP rules.
Please continue on Page 2 for more on EBITDA Calculation