EBITDA and the bridge to free cash flow

EBITDA is the number bankers reach for first, and beginners misread it constantly. Here's the honest version: EBITDA is a rough proxy for the operating cash profit a business makes before you account for how it's financed, how it's taxed, and how its accountants book non-cash items. It is useful. It is also not free cash flow, and confusing the two will cost you in a Superday.

What EBITDA is, and why bankers use it

EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Start from EBIT (operating income) and add back D&A:

$\text{EBITDA} = \text{EBIT} + \text{D\&A}$

Or build it up from the bottom of the income statement:

$\text{EBITDA} = \text{Net Income} + \text{Interest} + \text{Taxes} + \text{D\&A}$

Both roads land in the same place. Each add-back is deliberate, and knowing why each one comes back is the whole point:

| Add back | Why | What it strips out | | --- | --- | --- | | Interest | Financing choice, not operations | Capital structure | | Taxes | Depends on jurisdiction and structure | Tax regime | | D&A | Non-cash accounting allocation | Past capex decisions |

The reason bankers like EBITDA is comparability. Two companies can run identical operations, but one is loaded with debt and one has none. One sits in a high-tax state, one in a low-tax one. One took a big write-up in an acquisition and now carries heavy D&A. Their net income figures look nothing alike, yet the underlying business is the same. EBITDA scrubs out those differences so you can compare operating performance on a level field. That's exactly why the most common multiple in comparable company analysis is EV/EBITDA: enterprise value is capital-structure-neutral, and so is EBITDA, so the numerator and denominator speak the same language.

Why EBITDA is not free cash flow

Here's the trap. EBITDA sits high on the income statement, above three very real cash demands that it conveniently ignores. A business does not get to keep its EBITDA. It has to:

1. Pay cash taxes. The government takes its cut every year. EBITDA pretends taxes don't exist.
2. Reinvest in assets. Machines wear out, stores need refreshing, software needs building. That's capital expenditures, and it's a hard cash outflow. EBITDA added D&A back precisely because it's non-cash, but the actual spending that D&A represents still has to happen. High-capex businesses convert far less of their EBITDA into real cash.
3. Fund working capital. As a company grows, it ties up cash in receivables and inventory before customers pay. A rise in operating net working capital is a use of cash. (If that direction feels shaky, see working capital.)

Strip those three out and you get to what a business genuinely generates for all its capital providers: unlevered free cash flow.

The bridge, line by line

This is the walk you want in your back pocket:

$\text{UFCF} = \text{EBITDA} - \text{Cash Taxes} - \text{CapEx} - \Delta\text{NWC}$

Notice interest never appears. This is unlevered free cash flow, the cash available to everyone (debt and equity) before any lender is paid, which is exactly what you discount at WACC in a DCF.

Let's run clean numbers. Say a company has:

| Line | Amount | | --- | --- | | EBITDA | $100 | | less: D&A (to find EBIT) | ($20) | | EBIT | $80 | | less: cash taxes at 25% of EBIT | ($20) | | plus: D&A back (it was non-cash) | $20 | | less: CapEx | ($30) | | less: increase in working capital | ($10) | | Unlevered free cash flow | $40 |

So $100 of EBITDA becomes $40 of cash. The other $60 went to the taxman and back into the business. Same answer the tidy way:

$\text{UFCF} = 100 - 20 - 30 - 10 = \$40$

That gap between $100 and $40 is the whole lesson. It's why EBITDA is a starting point, not an ending point.

One nuance on taxes

Notice we taxed EBIT, not EBITDA. D&A is tax-deductible, so it shields income from tax before we ever add it back. Tax the wrong base and you overstate the government's take and understate cash. The order matters: compute the tax on operating income after D&A, then add the non-cash D&A back.

Adjusted EBITDA, quickly

You'll also hear "adjusted EBITDA," where management adds back things it calls one-time: restructuring, legal settlements, sometimes stock comp. Some of that is fair. A lot of it is a company dressing up its numbers. Treat every add-back with suspicion and ask whether the cost really won't recur. That skepticism is the mark of someone who reads statements for a living, not someone reciting a definition.