Accounting Fundamentals Glossary
Definitions for the most-used accounting terms in business analysis, with the formulas, ambiguities, and US-vs-elsewhere differences that come up in practice.
EBITDA
EBITDA is operating income with depreciation and amortization added back. It strips out the effects of capital structure (interest), tax jurisdiction (tax), and prior capital investment recognition (D&A) to produce a comparable measure of operating profitability across companies. Used heavily in valuation (see EBITDA multiples), in lender covenants, and in private equity reporting.
EBITDA's appeal is comparability; its weakness is that it ignores real expenses. A capital-intensive business with $10M EBITDA but $7M of annual capex has a very different cash profile than a software business with $10M EBITDA and $200K of capex. The phrase "EBITDA is not cash flow" is a hedge fund cliché because so many models treat them as interchangeable. Adjusted EBITDA — adding back one-time and non-recurring items — adds another layer of judgment that gets aggressively negotiated in M&A.
EBIT
EBIT is operating income — what the business earned from its operations before paying interest or tax. EBIT is closer to true profit than EBITDA because it includes depreciation and amortization (which represent the cost of using up capital assets), but excludes financing and tax effects so cross-company comparison is cleaner. For most operating businesses, EBIT and operating income are the same line; for businesses with non-operating income (investment gains, FX), they can differ.
COGS
Cost of goods sold (or cost of revenue, or cost of sales) is the direct cost of producing what was sold during the period. For a manufacturer: raw materials, direct labor, and factory overhead allocated to units produced. For a SaaS business: hosting, third-party APIs that scale with usage, customer support if classified at cost-of-revenue, and the people who provision and maintain customer environments. For a services business: the labor and direct expenses of the engagements that generated revenue.
The classification line — what counts as COGS vs. operating expense — has real consequences for reported gross margin, which is one of the most-watched ratios. Companies have meaningful discretion here, and comparison across companies in the same industry should always check classification before drawing conclusions.
Accrual vs. cash accounting
Cash accounting recognizes revenue when payment arrives and expenses when bills are paid. It's simple and matches the bank statement. Accrual accounting recognizes revenue when it's earned (the work is done or the product is delivered) and expenses when they're incurred (the obligation arises), regardless of when cash actually moves. Almost all companies above a small threshold use accrual; GAAP and IFRS require it for most reporting.
The key implication: in accrual accounting, profit is not cash. A company can be profitable on paper and bleeding cash if customers pay slowly; conversely, a SaaS business collecting annual contracts upfront can be cash-positive while reporting losses. The cash flow statement reconciles the two. See runway for why this matters in early-stage companies.
Deferred revenue
When a customer pays in advance, the cash is real but the revenue isn't earned yet. The company records cash on the asset side and deferred revenue on the liability side, then recognizes revenue ratably as the obligation is fulfilled. A 12-month SaaS contract paid upfront: $12,000 in cash, $12,000 in deferred revenue, then $1,000 of revenue and a $1,000 reduction in deferred revenue each month.
Deferred revenue is one of the most informative balance-sheet items for SaaS investors. A growing deferred revenue balance means the company is collecting future revenue faster than it's recognizing past revenue — a strong indicator of new bookings. A shrinking balance can signal slowing bookings or a shift to monthly billing. Bookings, billings, and revenue diverge precisely because of deferred revenue mechanics.
Depreciation and amortization
When a company buys equipment or licenses software, the cash leaves immediately but the benefit accrues over years. Depreciation (for tangible assets like machinery, vehicles, buildings) and amortization (for intangibles like patents, customer lists, capitalized software) spread the cost across the asset's useful life on the income statement. Common methods: straight-line (equal amount each year), accelerated MACRS (US tax method, more in early years), units-of-production (proportional to use).
D&A is a non-cash expense — the cash already left in an earlier period. That's why it's added back to compute EBITDA. But D&A reflects a real economic cost: the asset is being used up. A business that ignores its D&A and treats EBITDA as cash flow systematically under-funds eventual capex and replacement.
Capex vs. opex
Capital expenditure (capex) buys assets with useful lives longer than one year — equipment, buildings, sometimes capitalized internal-use software. The expense is spread over the asset's life via depreciation. Operating expense (opex) is consumed in the period — rent, salaries, marketing, most software subscriptions.
The classification has real financial consequences: capex doesn't hit current-period earnings (only the depreciation does), so capex-heavy businesses can show strong reported earnings while burning cash on equipment. The cloud transition shifted enormous spend from capex (data center hardware) to opex (cloud subscriptions), changing reported margins and balance sheet shapes across the software industry. Software development costs are partially capitalizable under both GAAP and IFRS, with rules that vary by country and by stage of development.
Goodwill
When Company A buys Company B for $50M and B's identifiable net assets (tangible plus identifiable intangibles like customer lists and IP) are worth $32M, the remaining $18M is recorded as goodwill on A's balance sheet. Goodwill captures the value of things that aren't separately identifiable — brand reputation, workforce, expected synergies. Under current US GAAP, goodwill isn't amortized but is tested annually for impairment; if the carrying value exceeds the recoverable amount, the difference is written off, often producing large one-time losses.
Goodwill is meaningful as a signal: a high goodwill-to-market-cap ratio means much of the company's accounting value comes from past acquisition premiums. It also flags potential future write-downs if those acquisitions underperform.
Working capital
Working capital is the cash and near-cash assets the business uses to fund day-to-day operations: cash, accounts receivable, inventory minus accounts payable and short-term debt. Positive working capital means the business has more current assets than current obligations; negative means the opposite — not necessarily a problem (it can indicate a powerful cash-cycle structure, e.g., subscription billing).
The cash conversion cycle (DIO + DSO − DPO) measures how many days of working capital the business needs. See the working capital calculator for the math. Reducing working capital intensity is often the fastest way to free cash from a profitable business.
Operating leverage
A business with high operating leverage has a high proportion of fixed costs in its cost base. Each additional dollar of revenue contributes most of its gross margin to operating income, because fixed costs don't grow. The flip side: each lost dollar of revenue removes that same contribution, with fixed costs unchanged. SaaS, software, media, and platform businesses are highly operating-leveraged; consulting and services are not.
High operating leverage explains why software companies' margins expand dramatically with growth and contract dramatically with declines. It's the same reason airlines and hotels are cyclical — high fixed costs amplify revenue swings into much larger profit swings. The break-even calculation embeds operating leverage; see the break-even calculator for the math.
Accruals and matching principle
The matching principle is the core rule of accrual accounting: expenses are recognized in the period when the related revenue is recognized, regardless of when cash moved. Sales commissions on a multi-year deal are spread across the deal life under ASC 606. Cost of goods sold is recognized when the goods are sold, not when they were produced. Bonus accruals build during the year against the bonus paid the following March.
The matching principle creates accruals — entries that recognize an expense (or revenue) before cash moves, with a corresponding asset or liability. The result is profit that reflects economic reality but diverges from cash. Reading any P&L without checking the cash flow statement misses half the story.