EBITDA
Earnings Before Interest, Taxes, Depreciation and Amortisation — a proxy for a company’s operating cash generation, widely used as the denominator in valuation multiples because it strips out capital-structure and accounting effects.
EBITDA · the mechanism
30 sec read
Say what EBITDA is for, get from it to free cash flow, and name the businesses where it lies.
Where it comes up. An MD asks why the target trades three turns below the sector when its EBITDA margin is the best in the set. The answer is usually capex, and it is usually not on the page.
Know what it strips out and why
Earnings before interest, tax, depreciation and amortisation. Removing interest makes it neutral to how the business is financed. Removing tax makes it neutral to jurisdiction. Removing depreciation and amortisation makes it neutral to the accounting treatment of capital spent years ago. That neutrality is the entire reason it exists.
Know what it ignores
Capital expenditure, working capital, cash taxes and interest are all real cash costs and EBITDA contains none of them. It is a proxy for operating cash generation, not a measure of cash.
Bridge it to something real
EBITDA, less cash taxes, less capex, less the increase in working capital, gives you unlevered free cash flow. The gap between the two is the whole question of whether a business converts its profit into money.
Worked through
Two businesses, both at $100m EBITDA.
- Software: capex
- $5m
- Software: unlevered FCF after $20m cash tax and $3m working capital
- $72m
- Cable network: capex
- $55m
- Cable network: unlevered FCF after $20m cash tax and $3m working capital
- $22m
Identical EBITDA, and one converts more than three times as much of it into cash. This is why a capital-intensive business trades at a lower EV/EBITDA multiple, and why an analyst who quotes EBITDA without capex has said almost nothing.
Check yourselfWhy did Charlie Munger call EBITDA "bullshit earnings"?
Answer once you have one →
Because depreciation is a real cost that has simply been paid already, and adding it back pretends the asset renews itself for free. For a business that must keep spending to stand still, EBITDA overstates economics permanently rather than temporarily. The defence is that it is a comparability tool rather than a cash measure, which is fine as long as capex is looked at alongside it.
Be able to say this back next week
- Said what it strips out and why that makes two businesses comparable
- Named what it ignores: capex, working capital, cash tax and interest
- Bridged it to unlevered free cash flow rather than treating it as cash
Why EBITDA matters in interviews
EBITDA is the denominator in the multiple most of finance runs on, and interviewers use it to test whether you treat it as a real cash flow proxy or as an accounting output with known weaknesses. Being able to argue both sides — why sponsors use it and why Buffett calls it misleading — is the answer that separates candidates.
How it works in practice
EBITDA is earnings before interest, taxes, depreciation and amortisation. From net income you add back taxes, interest, and D&A; from EBIT you simply add back D&A.
It is popular because it strips out capital-structure effects (interest), tax-jurisdiction effects (taxes) and historical accounting choices (D&A), making two companies comparable regardless of how they are financed or how aggressively they depreciate assets. That is exactly what a sponsor comparing acquisition targets wants.
In leveraged finance it is the unit of account: debt quantum is quoted as a multiple of EBITDA, covenants are set against it, and "adjusted EBITDA" — with add-backs for one-off costs, run-rate synergies and non-recurring items — is negotiated line by line in a credit agreement.
What candidates get wrong
- Calling EBITDA "cash flow". It ignores working capital movements, capital expenditure, cash taxes and cash interest. A capital-intensive business with high EBITDA can be free-cash-flow negative.
- Accepting adjusted EBITDA uncritically. Add-backs are where sell-side optimism lives, and quality-of-earnings work exists precisely to challenge them.
- Forgetting that adding back D&A implicitly assumes assets never need replacing, which is why EBITDA flatters capital-intensive sectors like telecoms and manufacturing.
EBITDA: frequently asked questions
Why do private equity firms focus on EBITDA?
Because it approximates the cash available to service debt before financing decisions, and because lenders size debt as a multiple of it. A sponsor evaluating a target wants a figure that is neutral to the seller's capital structure and tax position, since the sponsor will replace both after closing.
What is the main criticism of EBITDA?
That it ignores real costs. Depreciation is a proxy for capital that genuinely has to be spent to keep the business running, and EBITDA also excludes cash taxes, cash interest and working capital. For a business that must reinvest heavily just to stand still, EBITDA can overstate economic earnings substantially.
Where EBITDA comes up
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DCF interview questions guideRelated Valuation terms
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