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” and "Adjusted EBITDA" mean

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.

In the mergers and acquisition space, “Adjusted EBITDA” is often used to right-size for unusual, one-time, or non-recurring items included in a company’s financial statements in addition to the four adjustments noted above. A few high-level examples are off-market owner’s compensation, off-market rent expense, and personal expenses run through the business. Adjusted EBITDA serves as a primary baseline for market valuation of a business. 

Why investors use Adjusted EBITDA

Businesses may carry very different debt loads, face different tax situations, or own differing amounts of physical assets. Adjusted EBITDA allows an investor to study how efficiently a company converts revenues into operating profits. Through multiple methods, investors can utilize Adjusted 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 Adjusted EBITDA. A buyer might offer "six times Adjusted EBITDA," for example. If a business generates $5 million in Adjusted 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 and Adjusted EBITDA do not tell you

EBITDA and Adjusted EBITDA have real limitations, however. One of the blind spots is that they exclude 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 affect the liquidity of a business.

EBITDA and Adjusted EBITDA are not defined under generally accepted accounting principles, but that doesn’t mean they should not be utilized as a financial metric. Because EBITDA is a useful approximation of a business’s cash flow and helps develop enterprise value expectations once proper adjustment are made to reach Adjusted EBITDA, we encourage our clients to report EBITDA and Adjusted EBITDA on their internal financial statements. Understanding, growing, and managing to EBITDA and Adjusted EBITDA goals over time should significantly grow shareholder value.