EBITDA is the most widely used and most widely misused metric in corporate finance. It is used as a proxy for operating performance, a basis for valuation multiples, a benchmark for debt capacity and a target for executive compensation.
And it can improve while the company’s economic quality deteriorates.
EBITDA improves by deferring maintenance capex (the cost is real; it simply appears below the EBITDA line as depreciation rather than above it as repair expense). EBITDA improves by capitalising operating costs (moving an expense from above the line to the balance sheet, where it is amortised over years rather than charged immediately). EBITDA improves by extending asset useful lives (reducing depreciation without changing the economic consumption of the asset). EBITDA improves by leasing rather than owning (under certain structures, the lease cost is classified below EBITDA while the equivalent ownership cost of depreciation would be above).
In each case, EBITDA increases. In each case, the economic quality of the business has not improved and may have deteriorated. The company is not more profitable. It has reclassified costs in a way that makes the chosen metric look better while the underlying economics remain unchanged or worsen.
The EBITDA Reality Check
In Northrop Management Private Limited’s forensic and financial advisory work, EBITDA is never accepted at face value. It is tested through three reconciliations.
Reconciliation 1: EBITDA to operating cash flow. If EBITDA is Rs 100 crore but operating cash flow is Rs 50 crore, the difference (Rs 50 crore) represents working-capital consumption, non-cash revenue or costs below the EBITDA line that the metric ignores. The cash flow tells the board how much of the EBITDA is real in cash terms.
Reconciliation 2: EBITDA to free cash flow. If EBITDA is Rs 100 crore but free cash flow (after maintenance capex, working-capital change and tax) is Rs 30 crore, the company’s true cash-generating capacity is Rs 30 crore, not Rs 100 crore. The EBITDA multiple that investors apply should be adjusted downward to reflect the capital intensity that EBITDA ignores.
Reconciliation 3: EBITDA to maintenance-adjusted EBITDA. Add back only depreciation on growth capex. Leave depreciation on maintenance capex below the line (because maintenance capex is a genuine ongoing cost of running the business). The result is a metric that captures operating earnings after the cost of maintaining the asset base, which is a more accurate measure of sustainable earnings than standard EBITDA.
The comparison between reported EBITDA and maintenance-adjusted EBITDA reveals how much of the reported metric depends on the exclusion of costs that the business genuinely incurs.
Why the Illusion Persists
EBITDA persists as the dominant metric because it serves multiple constituencies simultaneously: management (whose compensation depends on it), investors (who use it for quick comparability), lenders (who use it for covenant testing) and advisors (who use it for valuation).
Each constituency has an interest in a metric that is easy to calculate, widely understood and consistently available. EBITDA meets all of these criteria. The fact that it can be improved through cost reclassification, capitalisation and depreciation management is a limitation that each constituency is aware of but tolerates because the alternative (a more accurate but less standardised metric) is harder to use.
Ashish Chaudhary, frames the analytical caution directly: “EBITDA is useful. It is not truthful. It tells you what the company earned before four categories of cost that every company actually pays: interest, tax, depreciation and amortisation. The question is not what the company earned before these costs. It is what the company earned after them. And the company that reports a rising EBITDA while its cash flow, maintenance requirements and working-capital consumption all deteriorate is a company whose most celebrated metric is its least reliable.”
Questions for the Boardroom
- What is the ratio of our EBITDA to operating cash flow, and is it improving or deteriorating?
- What is our free cash flow as a percentage of EBITDA, and what does the gap represent?
- If we calculated maintenance-adjusted EBITDA (excluding depreciation on growth capex but including depreciation on maintenance capex), how would the figure differ from reported EBITDA?
- Have any of our accounting choices in the last three years (capitalisation, useful life changes, lease treatment) had the effect of improving reported EBITDA without improving underlying economics?
- If our executive compensation were based on free cash flow rather than EBITDA, would management’s behaviour change?
Closing Implication
EBITDA can improve while enterprise economics deteriorate. The illusion persists because EBITDA is easy, standardised and embedded in every valuation, covenant and compensation framework.
The antidote is not abandoning EBITDA. It is never trusting it in isolation. Every EBITDA figure should be reconciled to cash flow, adjusted for maintenance capex and tested against the working-capital reality. The company whose EBITDA, operating cash flow and free cash flow all tell the same story has genuine earnings quality. The company whose EBITDA diverges from its cash flow has a metric that is improving while the business may not be.
About Northrop Management Private Limited
Northrop Management Private Limited is a forensic accounting, corporate governance and financial advisory firm headquartered at GRAPHIX Tower 2, Block A, Industrial Area, Sector 62, Noida 201301, with presence in Mumbai. Led by Ashish Chaudhary, Chartered Accountant, the firm advises boards, promoters, lenders, regulators and investors on forensic investigations, due diligence, financial reporting, capital allocation, governance architecture and enterprise diagnostics.
The firm’s proprietary frameworks include the Northrop Business Operability Index (NBOI), the Northrop Management Maturity Index (NMMI) and the Northrop Board Health Score (NBHS).
For advisory engagements, contact [email protected] or call +91 92899 25657.
www.northropindia.com
