Tessel Software, our fictional subscription business, reports $45 million of net income in FY3. An alternative we build from those accounts, EBITDA excluding stock-based pay, comes to $320 million.
The business has not sold another subscription. The number has grown because its definition has changed.
Before trusting the bigger headline, find what disappeared. Most of this gap comes from one recurring cost.
One business, several profit lenses
US GAAP, or generally accepted accounting principles, is the US framework for preparing financial statements. It sets rules for what gets counted and when. Companies still make estimates, such as how long a machine will last.
Like free cash flow, adjusted earnings is a non-GAAP financial measure: it changes what is included in a comparable GAAP number. Here the changes are to profit; “adjusted” does not mean “more accurate.”
A reconciliation is the bridge showing every change between the two results. It starts with reported profit from the income statement and lists each addition and subtraction. An earnings addback reverses an expense's effect on the measure. The expense remains in the accounts.
The bridge explains the gap. It does not justify it.
What EBITDA leaves out
EBITDA means earnings before interest, taxes, depreciation and amortization. D&A spreads asset costs across years of use. EBITDA removes those expenses, along with income tax and interest.
For Tessel, we remove both interest expense and interest income:
Tessel has no interest expense in FY3. Using its reported figures, in millions: $45 + $15 + $0 − $20 + $30 = $70.
Before adding the $30 million of D&A, the subtotal is $40 million. That is EBIT, earnings before interest and taxes. It equals Tessel's operating income, but other companies' EBIT can include non-operating gains or losses besides interest.
EBITDA helps compare earnings before differences in borrowing, income tax and asset accounting. Lenders still charge interest, governments still collect tax, and equipment still needs replacing. Removing a cost from the comparison does not remove it from the business.
Unlike operating cash flow, EBITDA does not adjust for unpaid customer bills or cash arriving before a sale is earned. Unlike free cash flow, it does not subtract capital spending. Adding back noncash expenses does not turn profit into cash flow.
Read Tessel's bridge
Tessel's $70 million EBITDA still deducts $250 million of stock-based compensation, or SBC: employee pay in shares or share awards. Excluding that expense gives $70 + $250 = $320 million.
That is calculated EBITDA excluding SBC—an illustrative definition of adjusted EBITDA. The final jump dwarfs the earlier steps because it removes so much employee pay.
The interest subtraction matters too. The $20 million was income, so removing it lowers earnings. “Before interest” works in both directions.
Tessel's accounts show the SBC expense across three years, in USD millions:
| Period | SBC expense |
|---|---|
| FY1 | $180 |
| FY2 | $220 |
| FY3 | $250 |
Three years, three charges. The biggest exclusion is part of paying people to keep the business running. The stock-based compensation lesson explains what that payment costs owners.
Ask whether the exclusions help
An impairment charge is another possible adjustment: a write-down when an asset fails the accounting test for supporting its recorded value. Excluding it can help separate current performance from a loss on an older investment. The write-down itself uses no cash, but the lost value still matters.
Three questions help you judge an exclusion:
- What question does it answer? Tessel's $320 million subtotal lets you study earnings before share pay and the costs EBITDA already removes. It can help track the rest of the business, but it favors Tessel over a company that pays the same compensation in cash and still deducts it.
- Is the definition consistent? If the exclusions expand, compare the bridge across periods before calling a larger number growth. A new label can hide a new calculation. A charge that returns every year needs a better explanation than “one-time.”
- Are gains and losses treated alike? Removing an unusual loss while keeping a similar gain tilts the picture toward better-looking results. An adjustment policy should work in bad years and good ones.
For historical results in US public company filings and earnings releases, SEC rules require the closest GAAP measure to be at least as prominent as the adjusted one, with a reconciliation between them. The SEC warns that excluding routine cash operating costs can mislead, even with a detailed bridge. Recurrence alone does not forbid an adjustment.
Read each company's interest convention and exclusions. Two identical labels can conceal different recipes; extra adjustments need a label such as “adjusted EBITDA.”
Keep both views in sight
Tessel's $320 million subtotal is useful only if you can explain why excluding $250 million of recurring employee pay helps the comparison.
There is a cash need outside both EBITDA figures too: Tessel spends $50 million on capital assets in FY3. Neither figure subtracts it. The earnings comparison cannot settle whether the business can fund its investments.
That distinction carries into debt and leverage, the next lesson. An earnings figure can help you size up a debt burden. Lenders still need cash.
In short
- An adjusted number is only as useful as the question its exclusions answer.
- EBITDA removes interest, income tax and D&A; it does not measure cash flow.
- Read the bridge to GAAP profit before trusting the headline.
- A fair comparison uses consistent exclusions and treats gains and losses alike.
- An exclusion from a metric does not erase its economic cost.