Should Your Business Be Fixated on EBITDA?

For many business owners, EBITDA comes up constantly: at the mastermind, in conversations with bankers, and as a yardstick for how your business stacks up against others. It's ubiquitous, controversial, and extremely nebulous. What the heck is it? In decades of working closely with more than 500 founders, I've heard the same sentiment almost every time. Business owners don't know exactly what EBITDA is, why it's so important, or how it's used, but they think they should.

The great Charlie Munger said it best: "I think that every time you see the word EBITDA, you should substitute the words 'bullshit earnings.'" Wall Street loves an easy button and tries to standardize financial terms across industries. Munger's point was that EBITDA varies so much from business to business, and can be manipulated so easily, that it often hides more than it shows. I suspect what he hated most was its cousin, "Adjusted EBITDA."

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It's supposed to measure a company's earnings potential. So let's look at how well it does that, what it's actually used for, and a better way to assess cash generation in your business.

Wait, isn't cash still king?

Warren Buffett famously said, "Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1." Most founders take this to heart and use their daily bank balance as a gauge of how the business is doing. They know it's crude, but it's an easy check with no Wall Street math required. And while it's limited, it's not a bad first place to look.

Still, I constantly hear, "We're making so many sales, so why doesn't the cash follow?" It happens in growing and steady businesses alike. The bank balance often doesn't move with revenue or net income, and owners can't figure out why. Since EBITDA is supposed to be a proxy for a business's ability to generate cash, is it the magic formula for a more sophisticated approach to cash management?

The Atma metric for cash flow

I don't think EBITDA is the one-metric answer. Businesses have such different revenue models, capital structures, and working capital needs that EBITDA alone can't tell you enough about cash or profitability. What it does approximate well is operating cash flow before working capital changes. In plain terms, it shows how much cash a business can generate before changes in receivables, payables, and inventory. For many businesses, the items below EBITDA have a major impact on cash and have to be factored in.

For the businesses we work with, we use a metric we call Adjusted Operating Cash Flow. It sounds like one of those subjective terms Munger would rail against, but it's a simple, objective measure of the cash a company's operations generate:

• EBITDA

• Less: increase in working capital (or plus a decrease)

• Less: recurring capital expenditures (excluding one-time investments)

• Equals: Adjusted Operating Cash Flow

That's it.

It works in large and small businesses, across industries, and in businesses with both high and low working capital needs. It doesn't account for taxes, debt payments, or financing. It shows an owner how much cash the business generated just to keep the lights on.

We look at it monthly, both as a historical trend and as a forward projection. It informs capital and expense decisions, uncovers working capital opportunities, and exposes the parts of the business that are soaking up too much cash.

So why does everyone talk about EBITDA?

If it isn't that useful for running a business on its own, why is everyone so focused on it?

It's simple: it's how deals are valued. If you want to know your enterprise value, you first need to know your EBITDA.

EBITDA is the language of the deal. In the industry's leading survey of investment bankers, adjusted EBITDA was the most-used valuation multiple, in roughly 3 out of 4 deals. Very small businesses are often priced on seller's discretionary earnings instead, which is essentially EBITDA before the owner's pay.

Some industries command higher multiples than others, and businesses in the same industry can earn higher or lower multiples based on size and performance. Investment bankers and business brokers will try to dress up EBITDA to fetch a bigger price, and figuring out a company's "actual EBITDA" becomes a song-and-dance show that rivals Bollywood.

Whether or not you plan to sell, you should know your EBITDA, if only to understand how a buyer would value your business. The best time to get a business ready is years before a potential exit, so it's put together the way buyers want to see it. That usually starts with maximizing EBITDA.

The new golf club metric

So the next time a fellow entrepreneur at the club mentions they sold their business for 15x EBITDA and makes you feel bad for not knowing yours, you can tell them they're talking "bullshit earnings," and that you talk in terms of Adjusted Operating Cash Flow.

About Atma Group

Atma Group gives founder-led businesses the financial leadership that private equity-backed companies take for granted, without giving up equity or control. Led by Raki Shah, CPA, a former CFO, CEO, and M&A leader, our team serves as the operating CFO for companies with 5M–100M in revenue. We start with audit-ready books and investor-grade reporting, and we partner with owners to build enterprise value whether they plan to hold, raise capital, or sell. To learn more, contact Raki at raki@atmagroupllc.com or visit atmagroupllc.com.

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