In the financial world, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) has risen to prominence as a key performance indicator. It dominates investor presentations, with companies routinely highlighting their EBITDA performance and growth trajectory. But we must ask: Does this metric deserve its exalted status, or are we being seduced by a metric that doesn’t tell the complete story?
EBITDA emerged during the leveraged buyout boom of the 1980s in the US. Investment professionals popularised this metric during a surge of corporate acquisitions, seeking a quick way to evaluate companies' operational performance and ability to generate cash.
EBITDA excludes financing decisions (interest), tax effects, and non-cash expenses (depreciation and amortization), enabling investment professionals to quickly get a clearer picture of a company’s operational efficiency and estimate its ability to service debt.
In the quest for simplicity, EBITDA has become a widely used metric to assess a company’s financial performance. Yet, this very simplicity comes at a cost—critical nuances are often overlooked, leading to a misleading portrayal of a company’s true financial health.
The core issue with EBITDA lies in what it excludes. By stripping away interest, taxes, depreciation, and amortization, it paints an incomplete picture, ignoring essential aspects of a business’s financial reality.
First, EBITDA overlooks the reality of capital expenditures. Depreciation, though a non-cash expense, reflects the real and ongoing costs of maintaining or replacing assets. Ignoring this masks the true cash flow required to sustain operations.
Second, by excluding interest payments, EBITDA obscures a company’s debt obligations, potentially hiding the risks associated with high leverage.
Third, taxes are an unavoidable expense that directly impacts the cash available to shareholders, yet EBITDA disregards this entirely.
Finally, EBITDA applies a uniform lens across industries, failing to account for the varying capital needs and operational realities that differentiate sectors. In doing so, it risks oversimplifying the complex financial landscapes businesses navigate.
So, if sole reliance on EBITDA could be misleading as a financial barometer of performance, what should investors and managers pay attention to? The simple answer is "it depends."
While free cash flow is often considered the gold standard, this answer doesn't adequately account for a company's growth stage. For example, mature and profitable businesses will likely demonstrate strong free cash flow generation, but start-up companies investing heavily in people and infrastructure might not be cash flow positive for years. Therefore, focusing on unit economics becomes critical for early-stage and growth-stage companies.
Unit economics examines the revenues, costs, and profits associated with a business model on a per-unit basis. This approach allows investors and managers to evaluate the fundamental economic viability of the business before it scales.
Key unit economic metrics include contribution margin, that is revenue minus variable costs per unit, and operational efficiency margins such as cash conversion cycles.
The message for business leaders and investors is clear: treat EBITDA as a starting point, not a conclusion. In a business landscape hungry for simple success metrics, EBITDA offers seductive clarity.
But like most simplified measures, what it omits matters more than what it includes. The next time someone champions their impressive EBITDA, remember to look beyond the illusion to the complete financial reality beneath.
The writer is the Vice President at Lightrock, a global investment platform | [email protected].
