A Practical Guide to EBITDA: What It Tells You—and What It Doesn’t!

When it comes to evaluating financial performance, EBITDA—Earnings Before Interest, Taxes, Depreciation, and Amortization—often takes center stage. It’s frequently touted as the go-to measure for assessing operational profitability. Yet, as Warren Buffett famously asked, “Does management think the tooth fairy pays for capital expenditures?” His critique serves as a caution: EBITDA can offer valuable insights, but it also has notable blind spots. Whether you’re running a family business, seeking funding, or positioning your company for a sale, understanding what EBITDA shows—and what it doesn’t—is essential.

What EBITDA Can Tell You

EBITDA is designed to isolate a company’s core operations, stripping out variables like interest, taxes, and accounting policies that differ from one company to another. By focusing solely on operational earnings, it can:

• Simplify Comparisons 

  By removing non-operational factors, EBITDA allows for straightforward benchmarking against industry peers.

  
  

• Highlight Operational Strengths 

  It offers a clear view of how a business performs before considering its capital structure or tax strategy.

  
  

• Ease Valuation Conversations 

  Buyers, investors, and lenders often use EBITDA to establish valuation multiples and assess operational efficiency.

For example, a company with strong EBITDA margins may be seen as efficiently managing costs and generating consistent revenue—an attractive signal to potential stakeholders.

Where EBITDA Falls Short

As straightforward as EBITDA may seem, it has its limitations. Specifically, it excludes:

• Capital Expenditures (CapEx)

  These are the investments needed to maintain or grow a business, such as replacing aging equipment or upgrading facilities. Ignoring these costs can lead to overestimating profitability.

• Debt Obligations

  Interest payments are real cash outflows that EBITDA disregards, which can significantly impact financial health.

• Working Capital Requirements

  Changes in receivables, payables, and inventory often affect cash flow but don’t appear in EBITDA calculations.

This makes EBITDA a useful but incomplete picture of a company’s financial health. As Warren Buffett’s quip highlights, omitting critical costs like capital expenditures can make EBITDA misleading, especially for capital-intensive businesses.

Illustrating EBITDA in Action

• Equipment-Driven Operations

  A manufacturing company proudly reports a $5 million EBITDA, signaling strong operational profitability. However, the business also incurs $2 million annually in machinery upgrades and maintenance—costs that are essential for keeping the business running. While EBITDA highlights efficiency, it doesn’t account for these ongoing investments, which directly impact cash flow and value.

  
  

• High-Growth Enterprises

  A logistics firm shows a rapidly growing EBITDA as it scales its delivery network. Yet, the growth is financed by substantial debt, leading to interest payments that consume a large share of the company’s cash flow. EBITDA might suggest profitability, but a deeper analysis reveals tighter margins when accounting for financing costs.

  
  

• Preparing for a Sale

  A privately owned construction company reports steady EBITDA growth, making it attractive to buyers. However, potential acquirers dig into the numbers and discover a significant backlog of deferred maintenance on equipment, which would require immediate capex. While EBITDA showed promise, it didn’t reflect the hidden costs necessary to sustain operations post-sale.

Finding Balance: How to Use EBITDA Wisely

EBITDA is a tool, not a definitive measure of a company’s financial health. To make the most of it:

• Pair EBITDA with free cash flow analysis to understand how operational earnings translate to actual liquidity.

• Include capex forecasts to account for the ongoing investments needed to sustain the business.

• Examine debt servicing requirements, especially for companies with leveraged capital structures.

When combined with a broader set of financial metrics, EBITDA becomes a valuable starting point for understanding profitability without overlooking critical financial realities.

Understanding EBITDA is crucial for evaluating operational performance, but it’s only part of the story. By acknowledging its strengths and limitations, you can make better-informed decisions about your business, whether you’re seeking funding, preparing for a sale, or planning for sustainable growth. Remember, metrics like EBITDA are most powerful when paired with a holistic view of your company’s financial health.

At Cairnstone Equity Solutions, we specialize in helping businesses like yours cut through the complexity of financial analysis. Whether you need guidance in valuation, capital restructuring, or business exit planning, we are here to provide the clarity and expertise you need.

Take the next step in securing your company’s future—contact us at info@cairnstone-equity.com to schedule a consultation and explore how we can help you achieve your financial goals.