What is EBITDA? And why adjusted EBITDA can mislead

EBITDA is a company's earnings before interest, taxes, depreciation and amortization. It shows what the day to day business earns before loans, tax and investments are taken into account. But EBITDA is not the same as money in the bank. Adjusted EBITDA leaves out even more costs. That can make the numbers look better than reality.

What does EBITDA mean?

EBITDA is an English abbreviation. Each letter stands for a part of the result:

The idea is to show how the business is doing, regardless of how the company is financed and what investments it has made.

How do you calculate EBITDA?

Take revenue and subtract the running costs, such as salaries, premises and purchases. What is left is EBITDA. If you already have operating profit (EBIT), you can instead add back depreciation and amortization.

Here is an example with an invented consulting company over one year:

The EBITDA margin is EBITDA divided by revenue. In the example, it is 15%.

Why is EBITDA not the same as money in the bank?

EBITDA leaves out several things that take money out of the account:

• Interest and loan repayments. Loans have to be paid, however well the business is doing.

• Tax. Corporate tax is paid on profit, not on EBITDA.

• Investments. When you buy a machine, the money leaves the account straight away. In the books, the cost is spread over several years as depreciation. EBITDA leaves out depreciation, so the purchase never shows in EBITDA.

• Change in working capital. If you invoice a lot in December and customers pay in January, the revenue shows in December but the money only arrives later. The same goes if you buy more goods for your stock: the money leaves before you have sold them.

Here is a simplified example for the same consulting company. During the year, it repays SEK 400,000 on a loan and buys new equipment for SEK 500,000. At year end, customers also owe SEK 600,000 more in unpaid invoices than at the start of the year:

The company has an EBITDA of SEK 1.5 million, but less money in the bank at the end of the year than at the start. That is why you need to follow cash flow separately, for example with a cash flow budget. If the company is making a loss, you can follow how fast cash is shrinking with burn rate.

What is adjusted EBITDA?

Adjusted EBITDA is EBITDA where the company itself leaves out more costs. Often these are costs the company sees as one off, such as a reorganisation, a move or an acquisition. The purpose is to show how the business is doing "in normal times".

The problem is that there is no common rule for what can be left out. Two companies can calculate adjusted EBITDA in completely different ways. According to the guidelines from ESMA, the EU's securities markets authority, listed companies in the EU must explain how they calculate the measure. Unlisted companies do not have to.

What does the WeWork case teach us about adjusted EBITDA?

WeWork leased offices on long contracts and then rented out workspaces on short agreements. According to Britannica's overview of WeWork, the company started showing its own measure, "community adjusted EBITDA", when it issued bonds in 2018. The measure left out major costs such as marketing, administration and design.

On that measure, WeWork showed a positive margin: CNBC reported in March 2019 that it was 28 percent for 2018. The same year, the company made a net loss of about 1.9 billion dollars, according to the IPO prospectus WeWork filed with the US Securities and Exchange Commission (SEC) in 2019.

The prospectus was heavily criticised. The IPO was postponed, and the prospectus was later withdrawn. According to Britannica, the valuation fell from 47 billion dollars to under 8 billion dollars in less than a year. On November 6, 2023, WeWork filed for bankruptcy protection for its US and Canadian operations, according to the company's filing with the SEC.

The lesson is not only for large companies. Every time someone leaves costs out of a result, the number gets better. The question is whether the costs really disappear, or whether they just do not show in the measure.

How do you use EBITDA in your own company?

EBITDA is useful, as long as you know what it shows and what it does not.

1. Always compare EBITDA with cash flow. Follow both every month. If EBITDA grows but cash shrinks, find out why.

2. Follow the margin over time. Compare with last year and with budget, not only with other companies in your industry.

3. Ask what was left out. If someone shows you adjusted EBITDA, for example in an acquisition or an investor presentation, ask for a list of all adjustments.

EBITDA is one of several metrics worth following every month. In acquisitions, the valuation is often based on a multiple of EBITDA, so the number can also affect what your company is worth.

Want to know how EBITDA and cash flow fit together in your company? Book a short call and we will go through your numbers.

Frequently asked questions

What is the difference between EBITDA and EBIT?

EBIT is operating profit, meaning the result before interest and tax. EBITDA also leaves out depreciation and amortization. That is why EBITDA is usually higher than EBIT.

What is a good EBITDA margin?

It depends on the industry. A consulting company with few assets and a manufacturing company with expensive machines have very different starting points. Compare with companies in the same industry, and with your own company over time.

Is it wrong to use adjusted EBITDA?

No, it is allowed and can be useful. But the measure is not standardised, so it only means something if you know exactly which costs were left out and why.

Sources: WeWork's IPO prospectus filed with the SEC (2019), WeWork's Chapter 11 filing with the SEC (November 2023), Britannica on WeWork, CNBC (March 2019) and ESMA's guidelines on alternative performance measures.