Understanding EBITDA - The Good, The Bad, and the Ugly

No one ever shuts up about EBITDA, but what is it really - and why is it important?

Apr 27, 2025

Walk into any interview or role in investment banking, private credit/equity, you name it — and one of the first buzzwords you’ll hear is EBITDA. And not just hear — it’ll be written all over every IC memo, CIM, and pitch book that hits your desk. People throw it around like it's the Rosetta Stone for understanding a business.

“How does their EBITDA margin compare to comps?”
“Can we lever this business at 5x EBITDA?”
“Are there any pro forma adjustments in our underwriting EBITDA?”

EBITDA might feel like one of those things you’re expected to know, but nobody actually sits down and explains properly. That's what we’re going to do here - break down the fundamentals of EBITDA. Why everyone cares about it, when you should not care about it, and how to actually think about it like an industry veteran.

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So What is EBITDA?

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s basically a way to look at a company's core operating performance before a bunch of messy, non-operational things get involved.

When you hear "before interest, taxes, depreciation, and amortization," think:
Before capital structure decisions. Before government obligations. Before accounting games.

It’s supposed to answer the question:
"If we just look at this business as a machine, ignoring how it’s financed or taxed, how much cash is it actually spitting out from its operations?"

Here's the Classic Formula:

EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization

Or if you start higher up the income statement:

EBITDA = Operating Income (EBIT) + Depreciation + Amortization

Example:
Imagine a small SaaS company that shows the following on its income statement:

Net Income: $1 million
Interest Expense: $500k
Taxes: $200k
Depreciation: $100k
Amortization: $50k

Then:

EBITDA = 1M + 500k + 200k + 100k + 50k = $1.85M

Voilà — $1.85 million EBITDA.
(Whoops - now some private equity firm with a fresh fund is trying to buy this business for 15x that number…)

Quick note - if you ever hear the term “Reported EBITDA”, that generally is referring to the same thing as the above. Reported EBITDA is what EBITDA is definitionally/literally, before any adjustments or other nuances which we’ll cover later in this post.

Why Is EBITDA Even Used?

The number one reason is comparability – by stripping out financing and tax structures, you can compare companies more easily across industries and geographies. Believe it or not, there can be good businesses with bad capital structures and bad businesses with good capital structures - and to a buyer, the current capital structure is irrelevant, because buyers are generally going to put a new capital structure in place (i.e. raise an appropriate amount of debt) at close anyway.

EBITDA is often used as a proxy for operating cash flow (wow, I sure do sound like a wall street prep course with that one). It’s true though - EBITDA isn't really cash flow, but it’s close enough sometimes, especially in services businesses where capex and working capital requirements are on the lighter side. Besides, we need to use something to evaluate deals right? EBITDA allows banks to underwrite loans based on EBITDA, and buyout firms can use multiples of EBITDA for valuation purposes - it generally works for both parties involved, until…

Meet Your New Friend (or Enemy): Adjusted EBITDA

The only thing you’ll hear more often on deals than EBITDA is Adjusted EBITDA. Unfortunately, Adjusted EBITDA is way more opaque than it’s definitional counterpart. It’s basically regular EBITDA... but with “normalization” adjustments (sometimes called EBITDA add-backs) to make the company look better, or at least different. If EBITDA is the pig, EBITDA adjustments are the lipstick that make the pig look more attractive to buyers.

Common Adjustments:

Non-recurring expenses (e.g., one-time legal fees, restructuring charges)
Run-rate synergies (e.g., "If we close the merger, we’ll save $10M a year through headcount reductions")
Management bonuses (yeah, I’m sure those were one-time payments….)

Translation: Adjusted EBITDA is EBITDA after management and bankers have thrown everything and the kitchen sink at it, at least when the business is being marketed.

To avoid being overly negative, sometimes these adjustments are warranted. If the business incurs $10 million of legal costs as part of the transaction, those really weren’t operational in nature and wouldn’t occur in a regular year - so those are generally accepted as an adjustment or add-back. If a business completes an acquisition and the target’s CEO and CFO are being axed (since the buyer already has a CEO/CFO), then it makes sense to add back those salaries to EBITDA since they won’t be go-forward costs. These types of adjustments happens more often than you’d think. Sometimes even non-cash items are added back - like stock-based compensation, or other non-cash losses - with the argument that these don’t impact cash flow anyway.

So when are adjustments not warranted? That’s part of your job as an underwriter. Take the following example - a business recently signs on a new client relationship that will generate $2 million of earnings in the first year, but since they’re a new client, that $2 million isn’t in the current trailing EBITDA figure. Should that be included? Well yes, and no - you can’t really answer without more information. If the business is a contracted, fixed monthly fee model with no ability for the customer to break the contract for the initial term which is 3 years - that feels a lot more like guaranteed EBITDA. Compare that to a general service agreement where revenue is volume based, but there are no minimum volume guarantees. How do you actually know they’re going to generate $2 million in earnings then? In both of these situations, you may lean into the adjustment differently.

At the end of the day, you don’t want to lever a business off of an inflated EBITDA figure that doesn’t accurately reflect true cash flow. That’s a surefire way to end up with an overlevered capital structure and a liquidity crunch is in your future. This is why when working on a deal, you often get a "reconciliation" schedule - namely a Quality of Earnings report - that shows a bridge from GAAP Net Income to Adjusted EBITDA. Learn to read these carefully — it's where all the bodies are buried.

EBITDA vs. Cash Flow: No, They Are Not the Same

One of the biggest mistakes you can make is thinking EBITDA = Cash Flow.
They are related, but not twins. Notably, EBITDA doesn’t include the following:

Capital Expenditures: Money spent on property, plant, equipment (PPE).
SaaS companies can generally scoot by without much of a capex need. Airlines, manufacturing companies, utilities... not so much.
Changes in Working Capital: If you sell a bunch of stuff but haven't collected the cash yet, or god-forbid you don’t collect the cash ever, EBITDA doesn’t care.
Debt Service: EBITDA happens before interest payments. Interest payments, however, are very much paid in cash.

So if someone says "the business generated $50M of EBITDA last year," that’s great, but you should be thinking, "how much free cash flow did it actually generate? Remember - cash is king. EBITDA is more like the young prince in training.

How EBITDA is Used in the LBO Market

In private equity and credit, EBITDA is basically the denominator of the entire deal.

Leverage Ratios:
Deals are often described as "5x leverage" — meaning total debt is 5 times EBITDA. (Ex: $10M EBITDA company, $50M of debt.)
Covenants:
Banks will require you to maintain certain leverage or coverage ratios based on EBITDA. It’s also how all the baskets are determined (baskets are essentially limits on the various items the borrower can do while the loan is outstanding).
Valuation Multiples:
Private companies are often valued at an "EV/EBITDA" multiple.
(EV = Enterprise Value. EV/EBITDA is quite literally the value of the company divided by EBITDA). This is the bread and butter of valuation comps.
Underwriting Models:
When lenders or buyers model out future cash flows in their LBO model, they often start with EBITDA and make assumptions about capex, interest, taxes, and working capital from there.

The good news is, buyers are generally aligned with lenders when looking at EBITDA. Just like how lenders don’t want to lever the business off of an inflated number, PE firms don’t want to buy off of an inflated EBITDA figure either - so they’ll be pouring through the Quality of Earnings alongside you to uncover any funny business. However, while this is true as part of new LBOs, it isn’t the case for existing portfolio companies - here, the sponsor will be painting as rosy a picture of EBITDA as possible to get more flexibility from its lender group. So you should be aware of how your role and dynamics change based on the type of deal you’re working on.

The Good, The Bad, and The Ugly (Criticisms of EBITDA)

Despite being a foundational item for the M&A market, EBITDA has some serious flaws. It’s easily manipulated through adjustments, it doesn’t reflect true cash obligations, and its usefulness varies by industry. Businesses can show a sky-high EBITDA figure in their reporting packages and still go bankrupt if there are heavy debt payments and capital expenditures involved. EBITDA is a necessary evil - and understanding how it’s used and abused is a critical component of working in private credit AND private equity - any role in M&A really.

Final Takeaways (i.e., Sound Smart in Interviews)

If you want to sound sharp in interviews, here’s some pointers on how to think about EBITDA:

It’s a proxy for operating performance, not actual cash flow.
You always need to dig into capex, working capital, and pro forma debt service to sanity-check whether a capital structure is appropriate.
Adjusted EBITDA can mean anything. You need to review the Quality of Earnings and form a view on how valid the adjustments are.
Remember: Leverage ratios, covenants, and valuations often hinge on EBITDA, so it’s important that the EBITDA figure you are underwriting is realistic (and not a pipe dream).

If you take nothing else away, remember what I was once told as a wee analyst:
In credit, EBITDA is like a first date. It shows you the pretty parts — but if you're serious, you better dig deeper before signing anything.