You probably know what EBITDA is, but why is it built that way?

Let's start with what it is: it’s an approximation of the profitability / operating cash flow of a business.

This operating cash flow serves as a basis for valuation and will be multiplied by some kind of multiple.

For example, $1,000,000 EBITDA x 8.0x = $8,000,000 valuation.

(the 8.0x is determined in the market by looking at comparable transactions for similar companies)

The key thing here: every $1 dollar of EBITDA is worth $8 dollars (at least in this example).

So you can imagine a seller wants the EBITDA as high as possible, whereas a buyer wants it as 𝘳𝘦𝘢𝘴𝘰𝘯𝘢𝘣𝘭𝘦 as possible (too low won’t attract buyers in the first place).

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Okay, got it, so 𝘸𝘩𝘺 do we include what we do?

We start with Net Income, and that’s easy enough, that is the “profit” or “earnings” of the company after all.

But Net Income 𝘪𝘴𝘯’𝘵 cash, we have to adjust it to get the (approximate) cash.

Let’s do the easy ones first: Depreciation & Amortization.

Those are 𝘯𝘰𝘯-𝘤𝘢𝘴𝘩 expenses, and we’re trying to build an approximate operating cash flow.

So we “add-back” those expenses to Net Income.

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The next one is a little trickier, Interest.

Why Interest?

Because a company could be purchased with all equity and wouldn’t need any debt, and therefore wouldn’t have Interest Expense.

So we “add-back” the Interest Expense to show what it would look like “debt free.”

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Next one is even trickier, Taxes.

Don’t we all have to pay taxes? So why add this back?

It all comes down to the business structure.

There are several business structures known as pass-through entities, meaning there is no “corporate income tax.” Rather, the taxes are “passed through” the business and end up on the personal returns of the members.

Typical pass-through entities would be S Corps, Sole Proprietorships, LLCs, and Partnerships.

The structure that is 𝘯𝘰𝘵 a pass-through is a C Corporation. This type of business would show an income tax expense on it’s income statement (whereas the other types would not).

So, that is why it gets added-back — we are showing a “tax-neutral” view of the business knowing that its business structure could change as part of an acquisition.

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In Summary:

Net Income = GAAP Profit
(+) D&A = neutralizes depreciation policies and are non-cash expenses
(+) Interest = neutralizes capital stack
(+) Taxes = neutralizes corporate tax structure
= EBITDA = a figure we can now compare to similar companies

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