Navigating with True North EBITDA: The Metric Behind Every Deal

Not perfect, but essential. Here's what it measures and why it matters.

by Luke Hunter

If you have ever heard investment bankers, merger and acquisition advisors, or private equity investors discuss buying or selling a company, you have almost certainly heard the acronym “EBITDA”. It is one of the most used terms in the language of deal-making, and while not a perfect financial metric, it is a key measure of the profitability of a business for an outsider looking in.

What “EBITDA” means

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Starting from a company's net income, you arrive at EBITDA by adding back four specific items:

• Interest expense on debt or leases
• Income tax expense recorded in the income statement
• Depreciation of capital equipment, and
• Amortization of intangible assets (e.g. patents or customer lists)

Because depreciation and amortization do not represent true cash outflows, adding them back gives a cleaner view of what the operations are truly generating from a cash flow perspective.

Why investors use EBITDA

Businesses may carry very different debt loads, face different tax situations, or own differing amounts of physical assets. EBITDA allows an investor to study how efficiently a company converts revenues into operating profits. Through multiple methods, investors can utilize EBITDA to quickly back-solve for what a business may be worth and decide whether to invest or pass on an opportunity.

Once a decision to invest is made, offers are generally submitted and compared using one of the most common measures of business valuations in M&A – a multiple of EBITDA. A buyer might offer "six times EBITDA," for example. If a business generates $5 million in EBITDA, a 6x multiple implies a purchase price of $30 million. That single equation drives billions of dollars in deal volume every year.

What EBITDA does not tell you

EBITDA has real limitations, however. One of the blind spots is that it excludes capital expenditures made to purchase equipment and other infrastructure needed to properly maintain or grow a business. Another blind spot is changes in working capital, which can significantly change the liquidity of a business.

EBITDA is not defined under generally accepted accounting principles, but that doesn’t mean it should not be utilized as a financial metric. Because EBITDA is a useful measure of a business’s cash flow and helps approximate enterprise value, we encourage our clients to report EBITDA on their internal financial statements. Understanding, growing, and managing to EBITDA goals over time should significantly grow shareholder value.