EBITDA

Two companies in the same business would often report completely different numbers at the bottom of the income statement — the table showing what was earned and what was left over across a period. Mixed into that bottom line were three things that say nothing about how well the business was run.

The first is how the money was raised. A company that borrowed from a bank pays interest every year; a company that raised investment doesn't. The second is where the taxes are paid. Rates differ by country, and carried-forward losses can put the tax line at zero for several years. The third is whether equipment is bought or rented. Buy your own servers and the cost is spread across years as depreciation; rent them and it lands in operating expenses (OpEx) month by month as you use them.

So acquisition reviews produced exchanges like this one. Someone says their operating profit is twice ours, and someone else answers that they lease all their hardware. Putting the two numbers side by side didn't mean anything.

EBITDA is the view you get after stripping those three back out. Remove the financing structure, the tax environment and the ownership of equipment, and what's left is how much the core business earns. The name spells out what's being excluded: earnings before interest, taxes, depreciation and amortization.

Take operating profit and add depreciation back. Operating profit is revenue minus cost of goods sold (COGS) and operating expenses, and depreciation is already sitting inside those operating expenses, which is why it goes back on.

Walk through one year at Pagedeck.

1. Start with $10 million in revenue and subtract $3 million in cost of goods sold — the server bills and payment fees that went directly into producing that revenue.
2. Subtract $6 million in operating expenses from the remaining $7 million. Salaries, rent and advertising live here. Operating profit comes to $1 million.
3. Add back the $500,000 of depreciation that was buried in those operating expenses. EBITDA is $1.5 million.

Depreciation goes back on because that money didn't leave the bank account this year. The company spent $1 million on hardware three years ago, all the cash went out then, and accounting spreads the cost across the years the hardware is used. The $500,000 on this year's statement is a leftover slice of an older purchase, not this year's spending. The cash question and the accounting question have different answers, and EBITDA answers neither of them on its own.

Working backward from net income lands on the same figure. Net income of $600,000 plus $200,000 of interest, $200,000 of tax and $500,000 of depreciation is $1.5 million.

One caution comes with it. EBITDA isn't a line defined by accounting standards; it's something you compute. Companies add back slightly different items, and some add stock compensation or one-off legal costs on top and call the result adjusted EBITDA. That's why the first question about any such number is what went into it.

Judge it as a share of revenue rather than as an amount. Divide $1.5 million of EBITDA by $10 million of revenue and you get 15 percent, which is the EBITDA margin.

Where the bar sits depends on where the company is.

1. A mature software company aiming at profit works with 20 to 30 percent. Revenue isn't growing much, so what matters is holding the share it keeps steady.
2. A fast-growing company is normally negative. While revenue doubles each year, money goes into sales and engineering first. The yardstick here is the rule of 40: add the growth rate to the margin and see whether the sum clears 40. Growth of 60 percent with a margin of negative 15 gives 45, which passes.
3. If the margin falls two years running and growth is falling with it, the money going in is buying less than it used to.

Whether the number says anything also varies by company. A business with factories or data centers carries heavy depreciation, so operating profit and EBITDA sit far apart. A software company renting its servers sees the two differ by a few percent. When a company with a small gap leads with EBITDA anyway, it's worth asking why not operating profit.

"Our EBITDA margin was 15 percent last year and we're targeting 20 percent this year."

A plan to lift core profitability by five percentage points, measured before depreciation and interest.

"They say they're profitable on EBITDA — did you check what their capital expenditure is?"

If a lot of cash goes into equipment, the bank balance can shrink while that number stays positive.

"Send me plain EBITDA, not adjusted."

Nobody knows what was added in, so give us the untouched figure.

EBITDA was the first thing Grace was asked about in the quarter Pagedeck was preparing its next raise. The investor wanted to see what the core business keeps at the current pace, and Grace gave the 15 percent figure along with the note that the depreciation inside it came from a server purchase three years back.

The follow-up question shows the limit of the measure. The investor asked what this year's capital expenditure (CapEx) would be. If more hardware gets bought this year, that money leaves the account without leaving a mark on EBITDA.

The most common mistake is reading EBITDA as cash flow. It adds back a cost that didn't move any cash, so it looks like what stays in the bank. But what got added back is a slice of an old purchase, and the equipment bought this year appears nowhere in it. A company that has to buy $2 million of new equipment every year and reports $1.5 million of EBITDA shows a positive number while its cash falls each year. Teams that trust the figure as cash and build hiring plans on it are the ones that can't cover payroll six months later.

A second misreading treats it as an official accounting figure. Revenue and net income follow defined rules, so any two people computing them land on the same answer; EBITDA doesn't work that way. When a seller's number comes in higher than a buyer's, it's usually not that one of them is wrong but that they added back different things. The fix is to ask for the list of add-backs rather than to argue about the total, since the two sides are usually describing the same business with different arithmetic.