Limitations of EBITDA as a Meaningful Financial Metric

In the franchise finance world, the most discussed number is the EBITDA—EBBADABADOO as some call it. EBITDA is earnings before interest, taxes, depreciation and amortization. It is really a sub-total to the income statement. It is earnings without any charges for cost of funds, taxes or capital spending.

EBITDA’s use began popularized as a credit metric, used in the 1980s M&A and credit analysis world—to test for adequacy of debt coverage. EBITDA is often the common denominator to track and report company buyout values:  the acquisition enterprise value to EBITDA ratio is a very commonly reported metric. So much so that that’s where the focus goes. And its use as a simple business valuation tool: the company is worth some multiple of EBITDA; the higher the multiple, the higher the price, and vice versa.

In the franchising space, where franchisors might report a simple EBITDA payback for an investment, or report EBITDA value in their franchise disclosure document item 19 section. The special problem there is this EBITDA is stated in terms of the restaurant level profit only—before overhead. Really, the problem is this: EBITDA doesn’t show the whole picture. It is a sub-total. It doesn’t show full costing.

EBITDA alone as the metric misses at least eight costs and expenses, that are vital to know, calculate and consider in operating and valuing the business as a cash and value producer.  Using a business segment such as a store, restaurant or hotel as an example, here are the eight required reductions to EBITDA that must be subtracted, listed in order of magnitude of the cash outlay, to really get to operating economic profit.

  1. Interest expense:  the cost of the debt must be calculated. Interest is amount borrowed times the interest rate times the number of years. One can have rising EBITDA but still go broke.

  2. Principal repayment:  the business cash flow itself should contribute to the ability to pay back the principal debt. That often is in a 5 or 7 year maturity note and is another very large cost that must be considered.

  3. Future year’s major renovation/remodeling: once the storefront is built, it has to be renewed and refreshed in a regular cycle, often every 5-10 years, via capital expenditures (CAPEX). That often is 10-30% of the total initial investment, or more, over time.

  4. Taxes, both state and federal: Financial analysis often is done on a pre-tax basis as there are so many complicating factors. But the reality is the marginal tax rate is about 40%.

  5. New technology and business mandates: aside from the existing storefront that must be maintained, new technology, and new business innovation CAPEX must be funded to remain competitive. Example: new POS systems for restaurants, new technology for hotels.

  6. Overhead: if the EBITDA value is stated in terms of a business sub-component, like a store, or restaurant or hotel, some level of overhead contribution must be covered by the EBITDA actually generated. Generally, there are no cash registers in the back office, and it is a cost center.

  7. Maintenance CAPEX: for customer facing businesses (retailers, restaurants, hotels, especially) some renovation of the customer and storefronts must occur every year and does not appear in the EBITDA calculations.  New carpets, broken windows, you get the idea. In the restaurant space, a good number might be 2% of sales.

  8. And finally, new expansion must be covered by the EBITDA generation, to some level. New store development is often a requirement in franchise agreements, and new market development necessary. While new funds can be borrowed or inserted, the existing business must generate some new money for the expansion.

You might say…these other costs and expenses are common sense, they should show up in the detailed cash flow models that should be constructed. Or they can be pro-rata allocated. But how times does this really happen? The EBITDA metric becomes like the book title….or the bumper sticker that gets placed on the car. You really do have to read further or look under the hood. And the saying is true…whatever you think you see in EBITDA…you need more.



When EBITDA is pushed as a justification for a company's valuation, the areas you are pointing out and others must be examined in more detail. Its not hard and does not take a lot of time to dig.

What the owner is faced with is that their EBITDA (in their mind = I am profitable) fantasy is shattered and they are faced with the brutal fact that their business is in the red and near worthless.

The history of EBITDA has its functions in the big business world, but it has been improperly applied to the SME markets where they don't have assets outside of their sales. Cloaking EBITDA just perpetuates the lie.

Buyers will be best served listening to your advise and sellers will need to deal with the reality.

BS is part of BSA

<p>Here&#39;s a good EBITDA calculator that CNNMoney gives to value your small business.</p>


<p>EBITDA is what small businesses use. SME analysts, entrepreneurs and small business guys use it for cross-business, cross-brand, cross-sector comparison.</p>

What two metrics do you

What two metrics do you prefer using when calculating return on investment and failure rate? For small business ROI, I think EBITDA is what one has to use. How about you? What metric do you think best? Why?

What metrics....

While figurers and counters everywhere define terms differently, the EBITDA less the 8 factors noted in my note, or operating economic profit has to be the superior metric. You can have positive EBITDA but run out of cash and hence to Chapter 7 or 11, quickly.

It is critical for franchisees to think in terms that EBITDA as a metric is not enough, one must think about the fulled loaded, hence lower number. In terms of SBA analysis and failure, I'd guess that is correlated to when the bank account runs dry multiple time and the entrepeneur throws up their hands.

John A. Gordon

Free Cash Flow & Payback Period

The only metrics important to me is free cash flow to dertermine a potential return on investment. We also evaluate FCF plus depreciation to determine a payback period and exit horizon. EBITDA is meaningless to us.

Excellent article John! See you in NY soon.

Anyone use Fintel for analytics?

Fintel is not a bad resource to use in gauging a small business ratios against industry benchmarks. Here's what I found for limited service restaurants.…

The full report is just over a hundred dollars, which seems pretty reasonable.

well sheesh

Now The Author is saying pretty much what I've been saying.  That EBITDA is greatly lacking for the individual Franchise Owner. I merely go further in conclusion for that the aspiring Mom & Pop operator that frequents BMM, calculating (or stopping at) an EBITDA number is a meaningless waste of time. The Mom & Pop operator doesn't make a living off their EBITDA, they need to estimate how much cash they'll have left at the end of the month or year.

As John says, they need more than EBITDA. They can go bankrupt with a positive EBITDA. They don't live on Earnings Before anything, they live on Earnings AFTER everything.

EBIDTA insufficient metric

One more perspective on the cost of the need for expansion not being measured- even if your franchise agreement doesn't technically require expansion, expansion will still cost you money. That's because the new unit going up across the street may belong to your franchisor or another franchisee.

The choice of doing it your self when the franchisor tells that the town needs a new unit might not even be available. Or if it is, it is at the barrel of a gun of an encroachment by someone else.

EBITDA + Cash Flow = Good

EBITDA + Cash Flow* = Good

*Historical cash flow and cash flow forecast

Excellent Comments regarding EBITDA limitations

John does an excellent job of identifying the limitations of EBITDA as a financial metric when analyzing a business.

Every financial metric has its limitations; one of the positive aspects of EBITDA is that it serves as a base comparison when one is investigating a myriad of business opportunities. It's a metric that can be used as a side by side tool, but even there it has its limitations.

For example if a buyer is looking at two business opportunities that require a similar investment and the first has a 20% EBITDA and a $1 Million dollar unit volume than that opportunity is delivering $200K - EBITDA. If it is being compared to another opportunity that has a 10% EBITDA but has a unit volume of $2 million it also delivers a $200K - EBITDA. Other metrics obviously need to be considered to get a full picture of the comparison such as CAPEX, Maintenance, Future Needs, Tax Predictions, etc. etc.

EBITDA remains a valuable financial metric, but EBITDA alone is not going to help you truly understand the cash flow, cash on cash return, or the future potential for the business. More due diligence needs to be conducted to truly understand rate the risk and the potential for the investment.

John is 100% accurate in identifying that making a business decision just based on EBITDA has its inherent risks.