EBITDA and Adjusted Earnings

Two companies sell the identical product and generate identical operating cash flow. One financed its factory with debt and depreciates it over ten years; the other paid cash and leases equipment instead. Their net income numbers will look nothing alike, even though the underlying businesses perform identically — one carries interest expense the other doesn't, and their depreciation schedules differ. EBITDA — earnings before interest, taxes, depreciation and amortization — exists to strip out exactly those differences and compare businesses on operating performance alone.

What EBITDA actually removes

Start from operating income (EBIT) and add back depreciation and amortization, non-cash charges that reflect accounting choices about how to spread an asset's cost over time rather than actual cash leaving the business this period.

$$\text{EBITDA} = \text{Net Income} + \text{Interest} + \text{Taxes} + \text{Depreciation} + \text{Amortization}.$$

In words: add back everything related to how the company is financed (interest), where it's taxed (taxes), and accounting depreciation schedules (D&A) — leaving a number meant to approximate the cash-generating power of the core operations before any of those choices are layered on.

A worked example

A manufacturer reports net income of $40m, interest expense of $15m, taxes of $12m, and depreciation and amortization of $25m.

$$\text{EBITDA} = 40 + 15 + 12 + 25 = 92\text{m}.$$

That is, $92 million.

A private-equity buyer comparing this company to an all-equity-financed competitor with the same EBITDA can now compare them on a like-for-like basis: strip away the target's $15m of interest (a financing choice the buyer can change) and its specific depreciation schedule (an accounting choice, not a cash reality), and both businesses generate roughly the same $92m of pre-financing, pre-tax operating cash power.

Adjusted EBITDA — where the abuse creeps in

Companies, especially around IPOs and leveraged buyouts, often report adjusted EBITDA, adding back further items management deems "non-recurring": stock-based compensation, restructuring charges, litigation settlements, even "lost deals" or "pro forma cost synergies" that haven't actually happened yet. Each individual add-back can have a legitimate rationale, but stacked together they can turn a company with real net losses into a headline "EBITDA" figure that looks robustly profitable.

What EBITDA leaves out that still costs real cash

EBITDA ignores capital expenditure entirely, even though most businesses have to keep spending on equipment and facilities just to maintain their current operations, let alone grow. A capital-intensive business — an airline, a telecom — can show a large, healthy-looking EBITDA while spending almost all of it on required capex, leaving little genuine free cash for shareholders. It also ignores working capital changes, which can silently consume cash even while EBITDA holds steady.