The Alphabet Soup of Profitability

Profitability sounds simple: add up what comes in, subtract what goes out, and you know where you stand. But anyone who has ever prepped their business for sale (or kicked the tires on a potential acquisition) knows it’s not that straightforward. Especially in the lower middle market, where financial reporting practices vary wildly, “profitability” is less a single number and more a choose-your-own-adventure story.

Four metrics tend to dominate the conversation: Net Income, EBITDA, SDE, and Free Cash Flow. Each highlights something different. Each can be useful. And each has blind spots that can lead you astray if you don’t understand what’s under the hood.

So let’s unpack the alphabet soup.

Net income: the GAAP gold standard

Net income is the classic “bottom line.” It’s total revenue minus every expense—operating costs, interest, taxes, depreciation, and amortization, etc. It’s the number accountants and public markets care about because it follows GAAP rules.

But, depending on the context, it can make small businesses look weaker or stronger than they really are. One-off events, depreciation schedules, and different capital structures all distort the picture. That’s why net income is useful in context, but rarely the whole story in private deals.

EBITDA: the middle market workhorse

EBITDA — earnings before interest, taxes, depreciation, and amortization — tries to strip out those distortions. It’s the go-to metric in lower middle market private equity because it lets you compare businesses without worrying about capital structure or quirky accounting choices.

But don’t mistake EBITDA for cash. As Charlie Munger once quipped, you could replace the word EBITDA with “bullshit earnings” and often be closer to the truth. It ignores capital expenditures, taxes, and working capital needs… all real uses of cash that determine what owners actually keep. 

Still, if you’re talking to bankers or investors, EBITDA is the language they’ll use.

SDE: the owner-operator’s lens

Seller’s Discretionary Earnings is what most small business owners really care about: how much money ends up in the owner’s pocket. It starts with net income, then adds back one-time expenses, non-cash charges, and owner perks like salary, benefits, or that company car.

It’s a great way to measure what an individual owner gets out of the business. But institutional buyers can’t just take SDE at face value — they’ll have to adjust it for professional management and scrutinize every add-back. It also presupposes a single owner-operator business structure, which might not be the case for some companies using SDE as their reporting metric of choice.

Free cash flow: the ultimate litmus test

Free cash flow is what actually shows up in the bank account after covering capital expenditures and changes in working capital. It’s the most “real” measure of profitability — what’s left to pay down debt, reward shareholders, or reinvest in the business.

The drawback? It’s harder to calculate and more volatile year to year. A big capex cycle or inventory swing can make the number jump around. But for long-term investors, free cash flow is the truest indicator of whether a business creates lasting value and is the basis of the most theoretically correct way to value a business through a discounted cash flow analysis.

Know the story, not just the number

Each metric tells a different story. Net income shows accounting profit. EBITDA shows normalized operating performance. SDE shows the owner’s take-home. Free cash flow shows what’s truly left. None of them are wrong… but none of them are interchangeable, either.

When it comes to valuation, the real work isn’t memorizing acronyms. It’s understanding which number matters in which context… and what it reveals about the business’s possible future. 

At City Different, we approach every acquisition with that mindset. Whether we’re evaluating a business that presents its profitability in terms of 

1. Net Income
2. EBITDA
3. SDE
4. FCF
5. All of the Above
6. None of the Above

our goal is to understand the company's true earning power and how that might evolve under new ownership.

Profitability isn’t just math… it’s narrative. And deciphering the true story makes all the difference.

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