Summary
Summary
- Net income is profit after everything: operating costs, interest, tax, depreciation and amortisation. It is shaped by financing and tax choices a buyer will change.
- EBITDA (earnings before interest, tax, depreciation and amortisation) strips those out to show operating profit before capital structure and accounting choices. It is the most common basis for valuing established private companies.
- Adjusted EBITDA removes one-off and owner-specific items to show normal, repeatable earnings. Buyers test every adjustment in quality of earnings work.
- Free cash flow is the cash left after running and reinvesting in the business. It is what actually services debt and pays owners, so buyers use it to check EBITDA.
- Small owner-run businesses are often valued on seller's discretionary earnings (SDE); larger ones on EBITDA; high-growth software on revenue or ARR.
01 · Guides
The earnings ladder
From revenue to net income, and back up to EBITDA.
| Measure | Starts from | Adds back or removes | Shows |
|---|---|---|---|
| Net income | Revenue | Deducts all costs, interest, tax, D&A | Bottom-line accounting profit |
| EBIT (operating profit) | Net income | Adds back interest and tax | Profit from operations after D&A |
| EBITDA | EBIT | Adds back depreciation and amortisation | Operating profit before capital intensity |
| Adjusted EBITDA | EBITDA | Removes one-offs, normalises owner costs | Repeatable operating earnings |
| SDE | Adjusted EBITDA | Adds back one owner's full salary and benefits | Total earnings available to one owner-operator |
| Operating cash flow | Net income | Adds non-cash items, adjusts for working capital | Cash generated by operations |
| Free cash flow | Operating cash flow | Deducts capital expenditure | Cash available for lenders and owners |
02 · Guides
Why buyers use EBITDA
Comparable across financing and accounting choices.
A buyer will refinance the business, may sit in a different tax position and may depreciate assets differently. EBITDA removes those items so the buyer can compare businesses on operations alone and apply a multiple. Enterprise value is then commonly expressed as a multiple of EBITDA; see enterprise value vs equity value.
EBITDA has limits. It ignores capital spending, so a business that must constantly replace equipment can look more profitable than it is. It ignores working capital, so a business whose customers pay slowly can have strong EBITDA and weak cash. That is why buyers always check EBITDA against cash flow.
Adjusted EBITDA
Adjustments, sometimes called add-backs or normalisations, aim to show earnings a new owner can expect. Some are accepted readily; others are where valuation gaps start.
| Adjustment | Usually accepted when | Usually challenged when |
|---|---|---|
| Owner salary above or below market | Replaced by a market-rate manager cost | The owner's role is not actually being replaced |
| One-off legal or restructuring costs | Clearly non-recurring and documented | Similar "one-offs" appear every year |
| Personal expenses through the business | Documented and clearly personal | They are really business costs |
| Transaction costs of the sale | Directly linked to the sale | Rarely challenged |
| Run-rate savings or new contracts | Already achieved and evidenced | Forecast, not yet delivered |
| Capitalised development costs (software) | Treatment is consistent and disclosed | Capitalisation flatters EBITDA versus peers |
03 · Guides
Cash flow: the check on EBITDA
Cash pays the debt and the owners.
Operating cash flow starts from net income, adds back non-cash charges such as depreciation, and adjusts for changes in working capital. Free cash flow then deducts capital expenditure. Lenders size debt on cash generation, and private equity buyers model returns on free cash flow after debt service.
- Cash conversionFree cash flow divided by EBITDA. A high ratio means earnings turn into cash; a low one prompts questions.
- Working capital swingsGrowth that needs more stock or longer customer credit consumes cash even when profit grows.
- Maintenance vs growth capexBuyers separate spending needed to stand still from spending that drives growth.
- Software specificsAnnual upfront billing can make cash flow stronger than EBITDA; capitalised development can make EBITDA look stronger than cash.
04 · Guides
A worked example
Hypothetical figures for one business.
| Line | Amount |
|---|---|
| Net income | $1.2M |
| Add back tax | $0.4M |
| Add back interest | $0.2M |
| EBIT | $1.8M |
| Add back depreciation and amortisation | $0.5M |
| EBITDA | $2.3M |
| Adjust: owner salary above market | +$0.15M |
| Adjust: one-off legal case | +$0.1M |
| Adjusted EBITDA | $2.55M |
| Less tax paid, change in working capital and capex | −$0.9M |
| Free cash flow (approximate) | $1.65M |
Here free cash flow is about 65% of adjusted EBITDA. A buyer would ask why: is working capital growing with sales, is capital spending catching up on past underinvestment, or is something else consuming cash? The answers affect both price and structure.
05 · Guides
Which number fits which business
Size and model decide the metric.
| Business profile | Usual basis | Why |
|---|---|---|
| Small owner-operated business | SDE | Buyer is often an individual replacing the owner |
| Established private company | Adjusted EBITDA | Comparable across financing; standard for PE and strategics |
| Capital-intensive business | EBITDA minus capex, or free cash flow | EBITDA overstates cash available |
| High-growth software | ARR or revenue | Profit is reinvested in growth; see [ARR vs revenue](/arr-vs-revenue/) |
| Mature software | EBITDA or free cash flow, with ARR quality | Profitability and retention both matter |
Run the numbers with the SDE and EBITDA calculator, which handles both EBITDA and SDE. For how earnings become the cheque, see M&A transaction costs.
Reference
Frequently asked questions
What is the difference between EBITDA and net income?
Net income is profit after all costs, interest, tax, depreciation and amortisation. EBITDA adds back interest, tax, depreciation and amortisation to show operating profit before financing and accounting choices.
Why do buyers use EBITDA to value a business?
Because it allows businesses with different debt, tax and depreciation to be compared on operations alone, and multiples of EBITDA are the common language of private company valuation.
What is adjusted EBITDA?
EBITDA with one-off and owner-specific items removed, so it reflects normal, repeatable earnings a new owner can expect. Buyers test each adjustment.
What is SDE?
Seller's discretionary earnings: adjusted EBITDA plus one owner-operator's full salary and benefits. It is used to value smaller owner-run businesses.
What is free cash flow?
Cash generated by operations after working capital changes and capital expenditure. It is what is available to repay lenders and reward owners.
Can EBITDA be high while cash flow is low?
Yes. Heavy capital spending, growing working capital or capitalised development costs can all leave cash flow well below EBITDA.
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About the analyst
Joash Boyton
Founder and Managing Director, Acquiry · Melbourne, Australia · Global coverage
Joash Boyton is the Founder and Managing Director of Acquiry, an M&A firm built around buy-side acquisition origination. He works with strategic acquirers, private equity firms and advisers supporting buyers on mandates from USD $1M to $500M. Most of the work sits in technology, SaaS, fintech, payments, gaming and digital assets, and it is not limited to them: any sector, any market.