EBITDA: Not a Defined Accounting Measure
EBITDA is earnings before interest, tax, depreciation and amortization, produced by adding depreciation and amortization back to EBIT. It is not a measure defined by any accounting standard, which means the company reporting it decides what the figure contains and what it excludes.
How it works
Take EBIT — earnings before interest and tax — and add back depreciation and amortization. Those are non-cash charges: allocations of the cost of an asset across the years it is used, rather than payments made this period.
Which makes it the largest profit figure available, always. Each measure removes another category of cost, so the order is fixed: this, then earnings before interest and tax, then net income. A company leading its press release with the largest of the three is making a presentational choice.
The cash-proxy argument, and what it leaves out
The argument for it is that depreciation is not a payment, so removing it gets closer to the cash the business generates. That argument is half right and the missing half is large: working capital movements and capital spending are both real cash and neither appears here.
Depreciation is not a payment and it is a real cost. The machine wears out. The vehicles are replaced. The software is rewritten. Adding depreciation back and then not subtracting what the company must spend to keep operating produces a figure that describes a business which never replaces anything.
The check that makes this readable takes thirty seconds: compare the depreciation being added back with capital spending on the cash flow statement. If capital spending is persistently larger, the add-back is describing money that has to be spent anyway.
And it flatters asset-heavy businesses most, because they have the most depreciation to add back — which is exactly the sector where the assets genuinely do need replacing.
It is not a defined measure
No accounting standard defines it. It does not appear on a statutory income statement. It is a calculation companies choose to present, and what goes into it is decided by the company presenting it.
The adjusted version compounds that. Adjusted figures remove items the company considers unusual — restructuring, share-based payment, acquisition costs, impairments. Some of those adjustments are reasonable and all of them are chosen by the party being measured.
Reconciliations to a statutory figure are normally required and normally published, and reading the reconciliation rather than the headline is the entire defense.
In practice
Its main legitimate use is as a valuation denominator. Enterprise value divided by this figure is the standard multiple in private equity and in takeover analysis, and it is used precisely because it is neutral to capital structure — which matters when the buyer intends to change the capital structure.
The margin version is the most flattering margin a company can quote, which is why it appears in presentations more often than in accounts.
And trading the shares on any of it pays the spread and any commission on every round trip, however good the story in the reconciliation sounds.
Put the capital-spending check on real numbers. A company reports 215 before interest, tax, depreciation and amortization, having added back 45 of depreciation and 20 of amortization. Its cash flow statement shows capital spending of 70. The depreciation added back was 45; the money actually required to keep the asset base intact was 70.
So the add-back overstated available cash by 25, every year, compounding. Subtract interest of 25 and that capital spending of 70 from the 215 and what remains is 120 before tax — against a headline that suggested more than 200. The check is one subtraction and it takes as long as finding the capital spending line, and it converts the most-quoted profit measure in corporate finance from a number to be trusted into a number to be tested.
What EBITDA is not
It is not cash flow. The cash flow statement exists for that and contains the capital spending this leaves out.
It is not a statutory measure. It appears in presentations, not on the face of the accounts.
It is not comparable between companies without checking definitions, especially in adjusted form.
And it is not free cash flow. That subtracts capital spending, which is the entire difference.
How this connects
It sits at the top of a sequence that starts with revenue. Subtract cost of goods sold for gross margin, subtract operating expenses for operating profit, and add back the non-cash charges to reach this figure.
Lenders build covenants on it. Covenant tests divide debt by this figure, and a debt service coverage ratio compares it with the interest and principal actually due, which is where the missing capital spending comes back to matter.
The debt-to-equity ratio shows the financing this figure ignores, and a company that borrowed heavily against a flattering multiple carries a higher interest rate burden than the headline suggests.
Credit analysts read a falling figure as rising credit risk, because the cushion protecting holders of each corporate bond is shrinking, and default follows when it runs out.
Companies often frame earnings guidance in adjusted terms, and the earnings report is where the reconciliation to the statutory line is published.
For long-term investors, a discounted cash flow model is the stricter alternative, since it subtracts capital spending before estimating intrinsic value.
And the full definitions sit in the 10-K and the notes to the financial statements, which is where the adjustments in any headline figure are spelled out.
When it fails
A company can grow this figure every year and run out of money. Interest is real, capital spending is real, and both are outside it. That combination — rising headline profit, falling cash — is not exotic; it is the standard shape of a leveraged, asset-heavy business in trouble.
The second failure is accepting the adjusted version at face value. The adjustments are selected by the company and the reconciliation is where they are visible.
A third is comparing it across capital intensities. An asset-light company and an asset-heavy one at the same multiple are not equivalently priced, because one of them has to spend far more to stand still.
A fourth is using it as a proxy for cash without the capital spending check. That single comparison disposes of most misuses.
And a fifth is treating a takeover multiple as a valuation. It is a convention used by buyers who intend to refinance, and it does not answer what a share is worth to a holder who will not.
The original data
Of the 24,971 trading and investing videos in this site’s corpus, “cash flow” returns 15 videos at a median of 67,134 views, “balance sheet” returns 3 at a median of 23,862, and “valuation” returns 8 at a median of 160,764. The relative strength index (“RSI”) returns 594 at a median of 5,377 and the moving average convergence divergence indicator (“MACD”) returns 471 at 3,645. Every figure counts each video a single time.
8 videos on valuation and 15 on cash flow, in a corpus of 24,971, and the most-quoted profit measure in corporate finance is taught inside them if at all. That is the finding, and it is checkable — the script and the corpus are both in this repository. The measures that determine whether a company survives are absent from the material a search surfaces, and the measures that determine what a chart looked like last Tuesday are everywhere. Which is a reason to read the reconciliation in a company’s own filing rather than a summary of it, because for this figure in particular there is no standard to fall back on.
Related
EBIT is the same measure with depreciation still subtracted. Operating income is the statutory line closest to both. And cash flow statement is where the capital spending this omits is recorded.
Pair it with capital spending every time. If the depreciation being added back is smaller than what the company has to spend each year to keep operating, the add-back is not a benefit to anyone — and that comparison takes about thirty seconds.
— Michael Whitman
This page is educational, not financial advice. Test every idea on your own charts before risking money.