Glossary
EBITDA: What It Means and What Diligence Tests
EBITDA is earnings before interest, taxes, depreciation and amortization. It describes operating earnings before the effects of how a business is financed, the tax position it sits in, and the non-cash charges it records against its assets. Because it removes those differences, it is used to compare businesses and to express price as a multiple.
In a transaction, ask which EBITDA is being presented. A figure calculated from reported results differs from one incorporating proposed adjustments. Quality of earnings work examines those adjustments and their support. The valuation and purchase-price mechanism depend on the transaction; not every deal is priced from adjusted EBITDA.
EBITDA in simple terms
Start with net income. Add back interest, income tax, depreciation and amortization. What remains approximates operating earnings before those four items.
It is a proxy. It is not free cash flow, and it is not the amount an owner can withdraw.
Reported, adjusted, and the number in the deal
Sellers usually present adjusted EBITDA, meaning reported EBITDA normalized for items argued to be owner-specific, one-time or non-operating. Each adjustment is a proposition, and each one has to be supported before it belongs in the number.
Two points are easy to miss.
Adjustments run in both directions. Normalization is not a synonym for adding back. Income determined to be non-operating may be removed, while an ongoing cost omitted from the starting figure may need to be restored. In our transaction discussions, sublease income has been assessed on that basis. Its treatment depends on the business and purpose of the analysis; it is not automatically excluded in every acquisition. Consider related costs consistently.
The lens changes the answer. An adjustment that is arguable in a sell-side presentation may be one we would not accept on the buy side. That is not a dispute about arithmetic. It is a difference in what the analysis is meant to isolate.
What normalization actually tests
In our transaction advisory work we review each of the categories below before an adjusted figure is settled. This is a review framework rather than a statement of how often any of these issues arises.
| Category | What is tested | Why the figure can move |
|---|---|---|
| Related-party rent | The lease the buyer will actually sign, not the rent the seller paid | Where premises are owned by the seller, historical rent is removed and a market rent for the go-forward lease is substituted. Terms, deposits and prepaid months also affect working capital. |
| Insurance | A current quote on the buyer’s own cover | A seller’s cover can sit inside a group arrangement the buyer will not inherit, so the go-forward cost can differ materially. |
| Owner compensation and benefits | Payroll records against the post-close plan | Distinguishes an owner’s pay from the cost of the management the business will still need. |
| Claimed personal expenses | Supporting documents, supplier purpose, expected post-close use | Where an expense cannot be verified, it stays in the analysis rather than being added back on the strength of the label. |
| Deferred and accrued revenue | Contract dates against invoice dates | Cut-off timing near a period end can move earnings substantially in either direction, without any change in the underlying business. |
| Non-operating income | Whether the income relates to operating the business | Removed, and with no matching cost, it comes straight off the bottom line. |
Where a go-forward cost is not yet known, the practical step is to establish it before the analysis concludes rather than after. On the buyer’s side that can mean obtaining the insurance quote or confirming the lease terms while the work is still open.
Cut-off is not a technicality
Deferred and accrued revenue deserve their own note because an accounting cut-off difference can change the reported figure without a corresponding change in operating performance.
An invoice date alone does not establish when revenue is earned. Assess the contract, performance completed and applicable accounting policy. Amounts billed or collected before the relevant work is performed may require deferral; work performed before billing may require an accrual. The appropriate treatment follows the facts, not how close the invoice is to year end.
This is one reason a single year is a weak basis for a price. Our quality of earnings work looks at multiple periods and a trailing twelve months alongside them.
What EBITDA does not tell you
The familiar criticism is that EBITDA ignores real costs, and it is fair as far as it goes. It excludes the capital a business must reinvest to keep earning, and it says nothing about the working capital that growth ties up. A business can report healthy EBITDA and still consume cash.
Three further limits matter in a transaction.
Concentration
Earnings can be at the expected level while resting on a small number of customers or a single contractor relationship. The number is the same. The risk attached to it is not.
Direction
A respectable annual figure can contain quarters that are declining year over year. The trend inside the period often matters more than the total.
Whether the earnings reconcile to cash
Testing recorded results against bank activity is a separate exercise. See proof of cash for how that reconciliation works and what it does and does not establish.
None of these are reasons to discard EBITDA. They are reasons not to treat it as a conclusion.
Frequently asked questions
What does EBITDA tell you?
It shows operating earnings before interest, taxes, depreciation and amortization, so two businesses can be compared on operations regardless of how each is financed or taxed.
What is EBITDA in simple terms?
Net income with interest, income tax, depreciation and amortization added back. It is a rough proxy for operating earnings, not for cash.
What is the difference between EBITDA and adjusted EBITDA?
Reported EBITDA comes from the financial statements. Adjusted EBITDA applies normalizing items argued to be owner-specific, one-time or non-operating. The adjustments are only as good as the evidence behind each one, which is what diligence examines.
Can an adjustment reduce EBITDA?
Yes, and a normalization exercise that only ever increases the figure is worth questioning. Removing non-operating income and restoring a cost the business will continue to carry both reduce it.
Is a 20% EBITDA margin good?
It depends on the industry. Margins are only meaningful against peers in the same business, and against the direction of travel within the period.
Why do some investors distrust EBITDA?
Because it excludes reinvestment and working capital. Earnings can look healthy while cash does not, which is why capital expenditure needs and working capital are examined separately.
Does Treewalk audit the EBITDA presented by a seller?
No. Treewalk does not provide audit or assurance services. A quality of earnings analysis is an advisory engagement that examines and reports on the adjustments and the evidence supporting them.
Where to next
For how each proposed adjustment is supported, read EBITDA normalization adjustments. For the owner-compensation question specifically, read seller’s discretionary earnings. For the full process, see the quality of earnings due diligence guide.
To discuss the earnings on a specific transaction, contact our transaction advisory team.
Treewalk, Chartered Professional Accountants, provides advisory services.
