EBITDA, adjusted EBITDA and add-backs

Key takeaways

• EBIT is operating profit before interest and tax; EBITDA adds back depreciation and amortization, and neither is defined by accounting standards.
• EBITDA is useful for comparing operating performance across capital structures, and it is the base for enterprise value multiples and leverage ratios.
• EBITDA ignores capex, working capital investment, taxes and, under IFRS 16, lease costs, so two businesses with equal EBITDA can generate very different cash.
• Adjusted EBITDA removes items presented as non-recurring or non-operating; each add-back should be tested for evidence, recurrence and whether a buyer will actually avoid the cost.
• A quality of earnings review both removes weak add-backs and adds negative adjustments management did not propose, so diligence-adjusted EBITDA is often below management's figure.
• Credit agreements define Consolidated EBITDA contractually, often allowing projected cost savings subject to caps, which is why covenant EBITDA can exceed any accounting measure.

EBIT and EBITDA defined

EBIT, earnings before interest and taxes, measures the profit a business earns from its operations before the cost of its financing and before income tax. In most income statements it is equal or close to operating income. It can differ when a company reports non-operating gains or losses, such as foreign exchange results or gains on selling investments, above the interest line, and analysts usually exclude those to get a clean operating figure.

EBITDA adds depreciation and amortization back to EBIT. Because D&A is often embedded in cost of goods sold and SG&A rather than shown as a line, the reliable source for the D&A figure is the cash flow statement or the notes. EBITDA can be built top-down, from revenue less cash operating costs, or bottom-up, from net income adding back tax, interest and D&A. The two routes must agree, and checking that they do catches most errors.

The EBITDA margin, EBITDA divided by revenue, is the most common profitability comparison in private equity. Related measures include EBITDAR, which also adds back rent and was widely used for retailers and airlines before leases came onto the balance sheet, and EBITDA less capex, a rough proxy for pre-tax operating cash flow.

Why buyers and lenders use EBITDA

EBITDA is capital structure neutral. Interest depends on how much debt the owner chose to use, and a leveraged buyout will replace the existing capital structure entirely. Tax depends partly on that financing and on the owner's jurisdiction and structure. Depreciation and amortization depend on historical purchase prices, useful life estimates and, after an acquisition, the purchase price allocation. Stripping all of these out leaves a measure of what the operations earn that a new owner can compare across targets and apply its own financing to.

That makes EBITDA the natural partner of enterprise value (EV), the value of the whole business to all capital providers. EV/EBITDA is the standard valuation multiple in buyouts and a common one in public markets. On the debt side, total debt or net debt divided by EBITDA is the standard measure of leverage, and interest coverage ratios frequently use EBITDA as the numerator. A lender sizing a loan at a multiple of EBITDA is using it as a rough measure of debt capacity.

EBITDA is also closer to cash than net income for many businesses, because D&A is the largest non-cash charge. For a company with modest capex, stable working capital and low taxes, EBITDA and operating cash flow track each other reasonably well. The trouble is that many companies do not fit that description.

The blind spots

Capital expenditure is the largest blind spot. EBITDA excludes depreciation on the argument that it is a non-cash accounting allocation, but the assets it depreciates were bought with cash and must be replaced with cash. A capital-intensive business can report a high EBITDA margin while generating little free cash flow.

Working capital is the second. A growing business that sells on credit or holds inventory must invest cash in receivables and stock before it collects. EBITDA records the sale but not the cash tied up. Taxes are the third: they are a real cash cost, and a company paying tax at a full rate converts less EBITDA to cash than one sheltered by losses.

Leases are the fourth, and they depend on the framework. Under IFRS 16 almost all rent is replaced by depreciation and interest, so it disappears from EBITDA. Under ASC 842 operating lease cost remains an operating expense. A store-heavy retailer reporting under IFRS can show materially higher EBITDA than an identical US peer. Finally, EBITDA ignores stock-based compensation when companies add it back, although it is a real cost to shareholders through dilution.

Adjusted EBITDA and the grading of add-backs

Adjusted EBITDA starts from reported EBITDA and removes items management argues do not reflect the ongoing earning power of the business. The adjustments are called add-backs when they increase EBITDA, which most do. Sellers present adjusted EBITDA in the information memorandum, buyers rebuild it in diligence, and the difference between the two figures, multiplied by the purchase multiple, is money.

Each proposed add-back should pass three tests. Is it evidenced, with invoices, contracts or payroll records rather than an estimate? Is it genuinely non-recurring, meaning it has not happened in prior years and is not likely to happen again? And will a new owner actually avoid the cost, or is the cost merely being relabeled? An item that recurs every year under a different name, such as annual restructuring, fails the second test even if every individual event is different.

Add-backs fall into broad families. Non-recurring items include litigation settlements, one-off professional fees for a transaction and costs of a closed site. Normalizations restate costs to what the business will bear under new ownership, such as founder salaries above or below market or rent paid to a related party at a non-market rate. Pro forma adjustments reflect events that occurred during the period as if they had occurred at its start, such as a full year of an acquired business. Run-rate adjustments claim the benefit of actions whose savings have not yet shown up, such as synergies or a pricing change. The further along that list, the more the figure relies on the future rather than the past.

A quality of earnings bridge

A quality of earnings (QoE) report, prepared by an accounting firm for a buyer or a lender, walks from reported EBITDA to management-adjusted EBITDA and then to diligence-adjusted EBITDA. The second step does two things. It accepts, reduces or rejects each management add-back, and it adds adjustments management did not propose, typically accounting corrections such as unrecorded accruals, revenue recognized too early, or costs capitalized that should have been expensed.

Bayview Dental Partners is a hypothetical group of dental clinics being sold. Management presents adjusted EBITDA for the last twelve months (LTM) of $24.1m. The buyer's QoE team works through the same bridge. Figures are in $m.

How credit agreements define EBITDA

In a leveraged loan or a private credit facility, EBITDA is a defined term, usually Consolidated EBITDA, written into the credit agreement. It drives the leverage and coverage covenants, the amount of additional debt the borrower may incur, the margin grid that sets the interest rate, and permissions such as paying dividends. The definition starts with consolidated net income and adds back interest, taxes and D&A, then lists further add-backs the parties negotiated.

Those add-backs commonly include non-cash charges, transaction costs, restructuring charges, and projected cost savings and synergies from actions taken or expected to be taken within a stated period, such as 18 or 24 months. Lenders limit the last category with caps, often expressed as a percentage of Consolidated EBITDA calculated before the add-back, and with requirements that the savings be reasonably identifiable and supportable. Pro forma treatment of acquisitions and disposals during the test period is standard.

The practical point is that covenant EBITDA is a contract, not an accounting measure. It can be materially higher than both reported EBITDA and a buyer's diligence-adjusted figure, and borrowers negotiate the definition as hard as the pricing. A lender reviewing a compliance certificate should reconcile covenant EBITDA to the audited accounts line by line.