EBITDA stands for earnings before interest, taxes, depreciation and amortization. It is a measure of a company's operating profit that removes four costs from the bottom line: the interest a company pays on its debt, the income taxes it owes, and the two non-cash charges known as depreciation and amortization. The aim is to show what the core business earns before those items.

How EBITDA is calculated

There are two routes to the figure, and they should land on the same number.

The first starts at the bottom of the income statement. You take net income and add back the four items: interest expense, taxes, depreciation and amortization. The second starts higher up, at operating income, often called EBIT, and adds back only depreciation and amortization, because interest and taxes already sit below operating profit. Wall Street Prep describes both routes and notes that the depreciation and amortization figure is often easiest to pull from the cash flow statement, where it is listed on its own line.

Depreciation and amortization are the parts that confuse people. Depreciation spreads the cost of a physical asset, a machine, a vehicle or a building, across the years the company uses it. Amortization does the same for intangible assets such as patents or acquired software. Neither is a cash payment in the year it appears on the income statement; the cash left when the asset was bought. EBITDA adds them back on the argument that they cloud a read on how much the business is currently generating.

Why companies lean on it

EBITDA is popular because it makes different companies look more comparable. Two firms in the same industry can carry very different debt loads and face different tax situations, and those two factors can dominate the income statement. Taking out interest and taxes lets an investor line up the operating businesses more directly.

It is also the number that private equity buyers and lenders anchor on. Debt is frequently priced as a multiple of EBITDA, and loan covenants are often written against it. For capital heavy businesses, telecoms, cable and heavy manufacturing, the depreciation line is large, and management argues that EBITDA shows the underlying cash engine more clearly than net income does. That argument has real merit, and it has a catch.

The part that is not GAAP, and why it matters

Here is the fact many quick definitions skip. EBITDA is not defined under United States generally accepted accounting principles. Revenue, operating income and net income are GAAP figures with rules behind them. EBITDA is not, which means a company has latitude in how it builds the number, and still more latitude once it moves to adjusted EBITDA, where it also takes out items it labels one off or unusual.

The Securities and Exchange Commission polices this. Under Regulation G, adopted in the 2003 rule on conditions for use of non-GAAP financial measures, and Item 10(e) of Regulation S-K, a company that discloses a measure such as EBITDA in its filings must reconcile it to the most directly comparable GAAP figure. The SEC's staff guidance says that figure is net income as presented in the statement of operations under GAAP. The same guidance bars presenting these measures per share.

The reconciliation requirement is the reader's friend. It means a careful investor can always trace the headline EBITDA back to audited net income and see every add back along the way.

When EBITDA flatters

Because the add backs are partly discretionary, EBITDA can paint a kinder picture than the cash reality. The clearest problem is that it ignores capital spending. A company that must constantly replace expensive equipment can show strong EBITDA while its actual cash is being consumed by the capital expenditure that EBITDA sets aside. As Wall Street Prep puts it, because depreciation spreads that spending across an asset's life, EBITDA can overstate cash generation, especially for capital intensive companies. It also leaves out the cash tied up in working capital.

Adjusted EBITDA widens the gap. With no fixed rulebook for what belongs in the number, management has room to add back ordinary running costs and call the result a cleaner view of the business. That is exactly the discretion the SEC's rules are built to contain, and it is why the reconciliation and equal prominence requirements exist.

To see where EBITDA sits among the numbers a company reports each quarter, our guide to how to read a company earnings report walks through the income statement line by line.

How to use it without being fooled

Treat EBITDA as one lens, not the whole view. Read it next to the GAAP figures the SEC requires beside it: net income, and the cash flow statement, which shows the capital spending EBITDA leaves out. When a company leads with adjusted EBITDA, find the reconciliation, look at what is being added back, and check how often a one off charge keeps recurring.

EBITDA also feeds valuation. Just as the price-to-earnings ratio compares a share price to profit, the EV to EBITDA multiple compares a company's enterprise value to its EBITDA, and it is the multiple most often quoted when a business is bought or sold.

The short version is that EBITDA is a useful measure of operating profit and a genuine aid to comparison, and it is a number the company has a hand in shaping. The rules around it exist precisely because it can be stretched.

What to watch

Watch the gap between EBITDA and free cash flow. When EBITDA looks healthy but the cash actually left over is thin, the difference usually lives in capital spending, interest or the add backs, and that gap is where the real story about a business tends to sit.