EBITDA

EBITDA stands for earnings before interest, taxes, depreciation and amortization, and it is computed by taking a company's net income and adding those four items back. The point of the exercise is comparability: interest reflects how a business chose to finance itself, income tax reflects its jurisdiction and structure, and depreciation and amortization reflect accounting allocations of costs incurred in earlier years. Stripping them out is meant to leave something closer to what the underlying operation produces, so that two businesses with different debt loads and different asset ages can be compared. It is not defined or required by accounting standards. Under SEC Regulation G it is a non-GAAP financial measure, meaning a numerical measure of financial performance that excludes amounts included in the most directly comparable GAAP measure.

The starting point is settled and frequently got wrong. SEC staff interpretation 103.01 addresses it directly: Exchange Act Release No. 47226 describes EBITDA as "earnings before interest, taxes, depreciation and amortization," and "'Earnings' means net income as presented in the statement of operations under GAAP." Interpretation 103.02 adds the corollary for presentation. Where EBITDA is shown as a performance measure it "should be reconciled to net income," and "operating income would not be considered the most directly comparable GAAP financial measure because EBIT and EBITDA make adjustments for items that are not included in operating income." So a calculation that begins at operating income and adds back depreciation and amortization is not EBITDA as the term is defined, because operating income has already excluded items that sit between it and net income.

The same interpretation polices the name. Measures "calculated differently than those described as EBIT and EBITDA in Exchange Act Release No. 47226 should not be characterized as 'EBIT' or 'EBITDA' and their titles should be distinguished from 'EBIT' or 'EBITDA,' such as 'Adjusted EBITDA.'" That is the origin of a label a reader meets constantly in private-company reporting, and it should be read as a warning rather than as a refinement: "adjusted" means somebody has added back something further, and what that something is has to be found in the footnote. Add-backs for one-time restructuring, litigation, founder compensation or "run rate" savings not yet achieved are all things a buyer or lender will test one by one. The interpretation also states flatly that these measures "must not be presented on a per share basis."

For a public company, disclosing EBITDA triggers real obligations. Regulation G defines a non-GAAP financial measure as one that excludes amounts included in, or includes amounts excluded from, the most directly comparable measure calculated and presented in accordance with GAAP in the statement of income, balance sheet or statement of cash flows. Once a measure falls inside that definition, Item 10(e) of Regulation S-K governs how it may be presented in filings, including the requirement to present the comparable GAAP measure and a reconciliation. A private business has no such obligation, and the absence of one is exactly why private-company EBITDA figures deserve the scrutiny they get: nothing compels the seller to show the bridge back to net income.

The substantive criticism of EBITDA is that the items it removes are not all optional. Interest is a real cash payment to a real lender, and taxes are a real cash payment to a real government; a business does not stop owing them because a metric ignores them. Depreciation is not a cash cost this year, but it stands in for assets that wear out and have to be replaced, so removing it flatters a capital-intensive business permanently rather than temporarily. And because the measure starts from an accrual profit figure, it also ignores movements in working capital: a business whose receivables and inventory are growing can post a rising EBITDA while its bank balance falls. None of that makes the measure useless, and it is the most convenient common denominator for comparing operating performance across businesses with different capital structures. It makes it a starting point rather than a conclusion, which is why the figure is normally read next to capital spending, the change in working capital, and debt service.

1. Start at net income, as reported under GAAP at the bottom of the income statement.

2. Add back interest expense, which reflects how the business is financed rather than how it trades.

3. Add back income tax expense, which reflects jurisdiction and structure.

4. Add back depreciation and amortization, the non-cash allocations of costs incurred in earlier periods.

5. Read it against the things it leaves out: capital expenditure, the change in working capital, and the principal repayments on the debt whose interest was added back in step 2.

Suppose a distribution business reports net income of $180,000. Its income statement shows interest expense of $45,000, income tax expense of $60,000, depreciation of $95,000 and amortization of $20,000. EBITDA is $180,000 + $45,000 + $60,000 + $95,000 + $20,000 = $400,000, and a reconciliation presented to a lender would show exactly those five lines, starting at net income. Now set the $400,000 against what the year required in cash. The business spent $120,000 replacing delivery vehicles and repaid $70,000 of loan principal, neither of which appears anywhere in the calculation, and its receivables grew by $55,000. Against $400,000 of EBITDA the business had $400,000 − $120,000 − $70,000 − $55,000 = $155,000 left before the $45,000 of interest and $60,000 of tax it also paid. The measure was not wrong; it was answering a different question from the one the bank balance was asking.

Pros

• It strips out financing and tax differences, which is what makes two businesses with different debt loads roughly comparable on operations.
• It removes non-cash allocations tied to the age and cost of assets bought in earlier years, so an old asset base does not make a business look weaker than a new one.
• It is the common language of business sale and lending conversations, so understanding it is necessary whether or not one approves of it.
• Built from the income statement, it can be computed for any business with ordinary accounts and no extra work.

Cons

• It is not cash flow and is routinely treated as though it were. Capital spending, working-capital movements and loan principal are all invisible to it.
• Adding back depreciation flatters a capital-intensive business permanently, because the assets really do have to be replaced.
• It is not a GAAP measure, so outside SEC filings nothing standardizes it and nothing compels a reconciliation.
• "Adjusted" versions proliferate, and the add-backs are where a seller's optimism lands.
• Interest and taxes are real payments, and a metric that removes them can describe as healthy a business that cannot meet them.