EBITDA Isn't the Whole Story: What Buyers and Lenders Really Want to Understand

You have spent years building your business.

Revenue is strong. The company is profitable. And perhaps your accountant, banker, business broker, or advisor has started talking about a number you are hearing more and more:

EBITDA.

Earnings before interest, taxes, depreciation, and amortization.

Maybe your EBITDA is $500,000. Maybe it is $1 million. Maybe it has grown substantially over the last few years.

That is important.

But it is not the end of the conversation.

For a buyer or lender, EBITDA often leads to a much bigger set of questions:

How dependable are those earnings? How much of them turn into cash? Where do they come from? What could make them disappear? And can the business continue producing them if the current owner leaves?

That is the financial story behind EBITDA.

And understanding that story before you need financing—or before you decide to sell—can be extremely valuable.

Consider two businesses.

Company A and Company B each report $1 million of EBITDA.

At first glance, they may appear financially similar.

But Company A has 500 recurring customers. No customer represents more than 3% of revenue. Margins have remained relatively stable for several years. The business requires relatively little new equipment, and an experienced management team runs day-to-day operations without the owner.

Company B also produces $1 million of EBITDA.

But one customer represents 45% of revenue. The company needs approximately $400,000 of equipment purchases each year. Margins fluctuate significantly. The owner personally handles the largest customers and generates most new sales.

Same EBITDA.

Very different financial story.

A buyer considering those companies is not simply asking, "How much does this business earn?"

The buyer is asking:

How much risk comes with those earnings?

A lender has a similar concern.

The lender wants to know whether the business is likely to continue generating enough cash to make its required debt payments.

That is why EBITDA is useful—but rarely sufficient by itself.

One of the first questions someone evaluating a business may ask is whether its earnings are sustainable.

Suppose your business had a tremendous year.

Revenue increased 25%, and EBITDA jumped from $700,000 to $1 million.

That sounds great.

But what caused the increase?

Was it the result of recurring customers and sustainable growth?

Or did the company land one unusually large project that may never happen again?

Those are very different situations.

A buyer may look at several years of financial results and ask:

• Is revenue growing, flat, or declining?
  
  
• Are gross margins stable?
  
  
• How much revenue is recurring?
  
  
• Are customer contracts long-term or easily terminated?
  
  
• Were there unusual revenue spikes?
  
  
• Are expenses increasing faster than sales?
  
  
• Have earnings been reasonably consistent?

The question underneath all of those questions is simple:

How confident can someone be that today's earnings will still exist tomorrow?

That does not mean a business needs perfectly predictable earnings.

Many good businesses are seasonal, cyclical, project-based, or affected by economic conditions.

What matters is whether those patterns can be understood and explained.

This distinction can surprise business owners.

A company can report strong EBITDA and still consume substantial amounts of cash.

Why?

Because EBITDA does not capture every demand on the company's cash.

Imagine a business with $1 million of EBITDA.

Now suppose the business regularly needs $350,000 to replace equipment.

It also needs additional inventory as it grows.

Customers take 60 days to pay, while employees and vendors must be paid much sooner.

And the company already has debt requiring regular principal and interest payments.

The $1 million EBITDA number is still meaningful.

But it does not mean the owner has $1 million of cash available each year.

A buyer or lender may therefore look closely at:

• Capital expenditures
  
  
• Equipment replacement needs
  
  
• Inventory requirements
  
  
• Accounts receivable
  
  
• Accounts payable
  
  
• Seasonal working-capital needs
  
  
• Existing debt
  
  
• Debt payments
  
  
• Other recurring cash requirements

A growing business can actually create additional cash pressure.

If sales increase rapidly but customers do not pay for 60 days, the company may need to fund payroll, materials, and operating expenses long before it collects the related revenue.

That is why the cash economics of the business matter so much.

EBITDA tells part of the earnings story. Cash flow helps explain what those earnings actually produce.

Another phrase business owners often hear is:

"That's an add-back."

Sometimes it is.

Privately held businesses frequently have expenses that a future owner may not incur in the same way.

For example, adjustments might be considered for certain owner compensation, family payroll, personal expenses paid through the business, one-time professional fees, unusual litigation costs, or other expenses that are not expected to continue.

But simply calling something an add-back does not automatically make it one.

A buyer or lender is likely to ask questions.

Was the expense really nonrecurring?

Would a new owner need to replace the owner's role with a paid employee?

Was the owner's compensation above or below a reasonable amount for the work performed?

Is an expense described as "one-time" actually appearing every few years?

If rent is being adjusted because the company occupies a building owned by the seller, what would market rent actually be?

These questions can materially change the analysis.

Suppose the business reports $800,000 of EBITDA and the owner proposes $300,000 of adjustments, producing "adjusted EBITDA" of $1.1 million.

The other side is unlikely to simply accept the $1.1 million number.

They may examine each adjustment.

Perhaps $150,000 is well supported.

Another $75,000 may be debatable.

And the remaining $75,000 may represent expenses that a new owner will still need to incur.

The discussion is not necessarily about whether add-backs are good or bad.

It is about whether they are supportable.

The stronger the documentation and reasoning behind an adjustment, the easier it is for someone else to understand why it belongs in the analysis.

Customer concentration is one of the easiest examples of why EBITDA alone does not tell the whole story.

Imagine two companies that each generate $5 million in revenue and $1 million in EBITDA.

The first company has hundreds of customers, and its largest customer represents 4% of annual revenue.

The second company has 50% of its revenue coming from one customer.

What happens if that customer leaves?

Even if the relationship has lasted 15 years, a buyer may want to understand the contract, renewal terms, competitive alternatives, relationship history, and whether that customer is tied primarily to the company or personally to the owner.

This does not automatically make the second company a bad business.

It does mean that its $1 million of EBITDA carries a different risk profile.

The same issue can arise with suppliers.

If the company depends on one critical vendor, one distribution channel, one salesperson, or one product, an outside party may want to understand what happens if that relationship changes.

For many closely held businesses, this may be one of the biggest questions of all.

The business may be extremely profitable.

But who is producing that profitability?

Suppose the owner:

• Maintains the major customer relationships
  
  
• Generates most new sales
  
  
• Approves every significant decision
  
  
• Negotiates with key vendors
  
  
• Holds important operating knowledge
  
  
• Resolves major customer problems
  
  
• Controls pricing
  
  
• Manages key employees

That arrangement may work very well while the owner is running the company.

It can look different to a buyer.

The buyer has to ask:

What happens to the earnings when the owner is no longer here?

If the answer is that someone else must be hired to perform several of those functions, that can affect the economics of the business.

If customers are loyal primarily to the owner rather than the company, that can create another concern.

And if important knowledge exists only in the owner's head, the buyer may see transition risk.

This is why preparing a business for an eventual sale is not simply about increasing profit.

It can also involve building a business that is capable of operating without depending on one person for everything.

That may mean developing managers, documenting processes, distributing customer relationships, strengthening the sales organization, and creating systems that survive the owner's departure.

Those changes can take years.

Which is exactly why they are worth thinking about before a sale is imminent.

Even a strong business can create uncertainty if its financial records are difficult to understand.

A buyer or lender may want several years of financial information.

They may compare financial statements with tax returns.

They may examine revenue trends, payroll, margins, debt, capital expenditures, receivables, inventory, and owner-related expenses.

And they may ask why something changed.

Clean financial records make those questions easier to answer.

Ideally, the books are current, reconciled, consistently prepared, properly classified, and supported by documentation.

Problems can arise when:

• Personal and business expenses are mixed together
  
  
• Financial statements do not reconcile with tax filings
  
  
• Accounts have not been reconciled
  
  
• Large year-end adjustments appear without clear explanations
  
  
• Expense classifications change repeatedly
  
  
• Documentation is missing
  
  
• The books require significant cleanup every year
  
  
• Accounting methods or policies change without a clear reason

The goal is not to make the business look better than it really is.

It is to make the financial history understandable and supportable.

That distinction matters.

Clean financial records are not only about preparing a tax return.

They may ultimately affect how confidently someone can evaluate the business itself.

A buyer is trying to understand what the business is worth to them and what risks come with owning it.

A lender has a different primary concern:

Will this business consistently generate enough cash to repay the loan?

That can lead the lender to examine many of the same issues from a different perspective.

Existing debt matters.

Working-capital requirements matter.

Capital expenditures matter.

Customer concentration matters.

Revenue volatility matters.

Management depth matters.

Collateral may matter, depending on the financing.

And cash flow available for debt service matters.

That is why a profitable company can sometimes be more difficult to finance than the owner expects.

The income statement may show healthy earnings while the cash-flow picture reveals substantial equipment needs, slow customer collections, significant existing debt, or large seasonal working-capital requirements.

For example, SBA lending policies require lenders to follow formal loan-origination and credit-analysis procedures, and certain SBA working-capital programs specifically require businesses to produce timely, accurate financial statements and supporting reports, such as receivable, payable, and inventory information.

In other words, the lender is not simply looking for a profitable business.

The lender is trying to understand the company's ability to support the proposed debt.

When owners begin thinking about selling a company, acquiring another business, refinancing debt, or bringing in an investor, they sometimes assume they need to start building the financial story from scratch.

Often, they do not.

Our firm may have years of information about the business.

That may include:

• Tax returns
  
  
• Financial statements
  
  
• Payroll history
  
  
• Owner compensation
  
  
• Capital purchases
  
  
• Debt
  
  
• Revenue trends
  
  
• Margin changes
  
  
• Unusual transactions
  
  
• Entity structure

More importantly, our office knows why the numbers changed.

That history can be valuable.

Why did margins decline two years ago?

Why did payroll increase?

Why was one year's income unusually high?

What explains the large equipment purchase?

Which owner-related expenses may need additional explanation?

Why do the tax return and internal financial statements differ?

Those are exactly the kinds of questions that can arise when someone outside the company begins looking closely at the business.

There is a common theme running through all of this.

You do not have to wait until you are selling the company to think like a buyer.

And you do not have to wait until you need a loan to think like a lender.

Look at your business from the outside.

How predictable are the earnings?

How much EBITDA actually becomes cash?

How dependent is the company on one customer?

How dependent is it on you?

Are your proposed add-backs well documented?

Could someone understand three years of financial statements without you sitting beside them explaining every number?

If the answer to some of those questions is uncomfortable, that can be useful information.

Because many of these issues are easier to address with time.

You can diversify customers.

You can strengthen management.

You can improve financial reporting.

You can document processes.

You can examine recurring capital needs.

You can clean up owner-related expenses.

You can establish better monthly reporting.

And you can build a financial track record that is easier for an outsider to understand.

There is nothing wrong with focusing on EBITDA.

It is an important measure, and it can be a useful starting point for discussing a company's financial performance.

But buyers and lenders rarely stop there.

They want to understand what is underneath the number.

Where did the earnings come from?

Are they likely to continue?

How much turns into cash?

What risks could reduce them?

How dependent are they on a few customers—or on the owner?

And how much confidence can someone place in the financial records supporting the number?

Those questions tell the broader financial story of the business.

If selling your business, acquiring another company, refinancing, or bringing in an investor may be part of your future, talk with our firm before the transaction begins.

We can help you look at your financial information from an outsider's perspective, identify areas that may create questions, and strengthen the financial reporting and documentation supporting the story your numbers tell.

The best time to find out what a buyer or lender may question is before they are the one asking.