EBITDA stands for earnings before interest, taxes, depreciation and amortization. EBITDA offers an alternative to operating cash flow for evaluating a company’s performance. EBITDA is similar in purpose to OCF in that it attempts to describe the actual cash generated by a company’s main business, but it is calculated differently.

Where the OCF calculation starts with net income, the EBITDA calculation starts with operating income, which is also described as EBIT, earnings before interest and taxes. EBITDA is calculated by adding back deprecation and amortization expenses to operating income. EBITDA is not defined by generally accepted accounting practices (GAAP), and it is not listed on most financial statements. In fact, MSN Money is the only site I’ve found that displays EBITDA as a separate line item on its income statements.

Calculating EBITDA is not difficult because operating income (EBIT) is listed on most income statements. You can compute EBITDA by adding depreciation and amortization charges to operating income.

EBITDA = operating income (EBIT) + depreciation + Amortization

Depreciation and amortization charges are listed on the cash flow statement, on the income statement, or both. Many companies report a figure that they call EBITDA in their earnings report press releases. However, since EBITDA isn’t an officially defined term, they often change the definition to make their numbers look better. If you want to use EBITDA, ignore the press release figure and look it up on MSN Money or calculate it yourself.

EBITDA does not account for changes in working capital, as does operating cash flow. That’s both a disadvantage and an advantage. Recall that comparing operating cash flow to net income helps to identify potential earnings quality issues, namely abnormal increases in accounts receivable and inventory levels. So using EBITDA in place of operating cash flows requires that you do the math and compare accounts receivables and inventory levels to sales to warn of earnings quality issues.

Some analysts ignore working capital changes believing that receivables and inventories often change in response to short-term market conditions, but end up pretty much where they started in the long run. For them, EBITDA is a better measure than operating cash flow. A major advantage of using EBITDA is that it isn’t inflated with dubious entries such as deferred income taxes and employee stock option income tax benefits. Watching EBITDA instead of operating cash flow also avoids being misled by unusual working capital changes. Dell Computer provides a good example of how EBITDA can give you a better reading than cash flow.

Dell increased its accounts payable account, the money owed to suppliers, by $1.1 billion in the year. Recalling the math, increases in accounts payables add to working capital while additions to inventory levels and accounts receivables subtract. By taking longer to pay its suppliers, Dell was able to report a $509 million increase in operating cash flow based solely on changes in its working capital.

Many pundits pooh-pooh EBITDA as a self-serving standard devised by company executives to improve the appearance of their operating results. You be the judge.

Free EBITDA

Just as subtracting capital expenditures from operating cash flow gives you free cash flow, you can calculate the EBTIDA equivalent of free cash flow; call it free EBITDA, by subtracting capital expenditures from EBITDA:

free EBITDA = EBITDA – capital spending

Since using EBITDA in place of operating cash flow smoothes out the volatility caused by dubious operating cash flow entries and by short-term working capital changes, free EBITDA should give a better picture of a firm’s cash flow after accounting for capital expenses than the traditional free cash flow measure.