What lenders and investors really look for in your financials

When businesses seek funding, whether through banks or investors, their financial statements undergo meticulous scrutiny. Among the key financial metrics assessed, EBITDA stands out as one of the most widely used indicators of business performance. While it is an essential metric, it is not the only one that matters.

Understanding how EBITDA fits into the broader financial landscape and why other metrics such as Free Cash Flow (FCF) are just as important provides a more complete picture of what funders are looking for.

EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortisation, is a measure of a company’s operating performance, independent of its capital structure, tax obligations, and non-cash expenses. It provides a clearer view of the company’s ability to generate earnings before accounting for financial and structural costs, making it an attractive metric for banks and investors. Lenders favour EBITDA because it indicates how much income a company has available to service its debt. Investors, particularly private equity firms and institutional investors use EBITDA to compare companies across industries, as it neutralises differences in tax regimes and accounting policies, following the principles set out by IFRS.

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EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortisation, is a measure of a company’s operating performance, independent of its capital structure, tax obligations, and non-cash expenses. It provides a clearer view of the company’s ability to generate earnings before accounting for financial and structural costs, making it an attractive metric for banks and investors. Lenders favour EBITDA because it gives an indication of how much income a company has available to service its debt. Investors, particularly private equity firms and institutional investors, use EBITDA to compare companies across industries, as it neutralises differences in tax regimes and accounting policies, following the principles set out by IFRS.

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Beyond its role as a profitability measure, EBITDA is also used extensively in financial modelling and valuation. One of the most common valuation methods is the Enterprise Value to EBITDA (EV/EBITDA) multiple. This ratio helps investors determine whether a company is undervalued or overvalued in comparison to its peers. A lower EV/EBITDA multiple may suggest that a business is undervalued, whereas a higher multiple may indicate strong growth expectations or an overvalued entity.

Additionally, leveraged buyout (LBO) models rely on EBITDA to assess a company’s ability to take on and repay debt, as debt repayment capacity is directly linked to EBITDA growth. Lenders, too, use Debt-to-EBITDA ratios to evaluate financial leverage and risk. Companies with high Debt-to-EBITDA ratios may be seen as financially unstable, potentially jeopardising their ability to secure financing on favourable terms.

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Despite its utility, EBITDA alone does not provide a comprehensive assessment of a company’s financial health. Investors incorporate additional financial metrics to obtain a clearer understanding of business viability. Revenue growth, for instance, indicates the company’s ability to expand its market share, while gross margin highlights operational efficiency at a fundamental level. Operating income (EBIT) refines the EBITDA measure by considering depreciation and amortisation, thereby offering a more precise representation of actual profitability. Net income, which accounts for all expenses, including taxes and interest, remains an indispensable metric for assessing the true profitability of an enterprise.

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While profitability metrics are important, cash flow remains a key consideration for both lenders and investors. Free Cash Flow (FCF) is particularly significant, as it measures the actual cash available to a business after accounting for capital expenditures. Unlike EBITDA, which omits essential costs such as equipment purchases and infrastructure investments, FCF provides a realistic view of a company’s liquidity. Investors are keen on FCF because it demonstrates whether a company has sufficient cash to reinvest in growth, pay dividends, or service debt. Strong free cash flow generation typically signals a financially sound business with a capacity for sustainable expansion. Conversely, a business that boasts a high EBITDA but struggles with FCF may face liquidity issues, which could deter investors.

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Understanding the importance of these financial metrics also requires acknowledging their limitations. EBITDA is a useful indicator of operating performance, but it does not represent actual cash generated by a business. It ignores capital expenditures, working capital requirements, and changes in financial obligations, which are crucial for assessing a company’s day-to-day financial health. While banks and investors often use EBITDA as a starting point, they ultimately look at cash flow to determine long-term viability. Businesses that focus solely on EBITDA risk overestimating their financial strength, potentially leading to liquidity constraints. For businesses themselves, the ability to manage cash flow effectively is often the true measure of financial success.

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This leads to an even broader discussion: the importance of cash flow management in business operations. While EBITDA plays a role in securing funding, maintaining positive cash flow ensures a company can meet its obligations, reinvest in growth, and weather financial downturns. Understanding cash flow dynamics is critical for long-term sustainability, making it a subject that deserves its own in-depth analysis. In the next article, we will explore why cash flow is the lifeblood of a business, how it differs from profit, and the best practices for effective cash flow management.

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