Understanding EBITDA as a Measure of Business Performance

What EBITDA measures and why it is used

By stripping out interest (which reflects capital structure), tax (which reflects jurisdiction and group planning), depreciation and amortisation (which are non-cash accounting charges), EBITDA attempts to isolate the cash-generating capacity of the core operating business. This makes it more comparable across companies with different debt levels, tax positions, and asset bases.

Lenders use EBITDA as the denominator in leverage ratios (net debt divided by EBITDA) and as the numerator in interest cover ratios (EBITDA divided by net finance charges). Both are common financial covenant metrics in term-loan and revolving-credit facilities.

Adjusted EBITDA and addbacks

Management EBITDA, or adjusted EBITDA, normalises the reported figure for one-off items: restructuring costs, legal settlements, one-time advisory fees, or the cost of terminated operations. Lenders will scrutinise addbacks carefully — excessive or recurring 'one-off' items are a red flag, and lenders may cap total addbacks as a proportion of unadjusted EBITDA.

The definition of EBITDA in your facility agreement governs how covenant tests are calculated. Directors should ensure the definition captures legitimate addbacks specific to the business — for example, capitalised development expenditure or above-market management charges from a related party that will be adjusted post-acquisition.

Limitations of EBITDA

EBITDA does not equal free cash flow. It ignores changes in working capital (a business growing rapidly can have strong EBITDA but consume large amounts of cash funding debtors and stock), capital expenditure requirements, and mandatory debt repayments. A capital-intensive business with £2m EBITDA and £1.5m annual capex has very different cash availability than a services business with the same EBITDA and negligible capex.

• Track free cash flow (EBITDA minus capex minus working-capital movement minus debt service) alongside EBITDA
• Understand which definition of EBITDA your lender uses in covenant calculations — ask for the formula explicitly
• Be cautious of valuations expressed as a multiple of EBITDA without understanding the quality of earnings behind the figure