What is EBITDA vs. Cash Flow?
EBITDA is often used as a proxy for cash flow, but many practitioners struggle to grasp the true meaning of EBITDA fully.
There are misconceptions surrounding the usage of EBITDA in the context of valuation and how EBITDA is different from cash flow from operations (CFO) and free cash flows (FCF), which the following post will aim to clear up along with presenting some practical examples.
EBITDA vs. Cash Flow from Operations (CFO)
First, let’s look at cash from operations (CFO). The main advantage of CFO is that it tells you exactly how much cash a company generated from operating activities during a period of time.
CFO is an extremely important metric, so much so that you might ask, “What’s the point of even looking at accounting profits (like Net Income or EBIT, or to some extent, EBITDA) in the first place?”
We wrote an article about this here, but to summarize: Accounting profits are an important complement to cash flows.
Imagine if you only looked at cash from operations for Boeing after it secured a major contract with an airliner. While its CFO may be very low as it ramps up working capital investments, its operating profits show a much more accurate picture of profitability (since the accrual method used for calculating net income matches the timing of revenues with costs).
However, we should not rely solely on accrual-based accounting, either, and must always have a handle on cash flows. Since accrual accounting depends on management’s judgment and estimates, the income statement is very sensitive to earnings manipulation and shenanigans. Two identical companies can have very different income statements if the two companies make different (often arbitrary) deprecation assumptions, revenue recognition and other assumptions.
The benefit of CFO is that it is objective. It’s harder to manipulate CFO than accounting profits (although not impossible, since companies still have some leeway in whether they classify certain items as investing, financing or operating activities, thereby opening the door for manipulating CFO). The flip side of that coin is CFO’s primary downside: You don’t get an accurate picture of ongoing profitability.
Free Cash Flow vs. Operating Cash Flow
Free cash flow (FCF) actually has two popular definitions:
- FCF to the firm (FCFF): EBIT*(1-t)+D&A +/- WC changes – Capital expenditures
- FCF to equity (FCFE): Net income + D&A +/- WC changes – Capital expenditures +/- inflows/outflows from debt
Let’s discuss FCFF, since that’s the one investment bankers use most often (unless it is a FIG banker, in which case he/she will be more familiar with FCFE).
The advantage of FCFF over CFO is that it identifies how much cash the company can distribute to providers of capital, regardless of the company’s capital structure.
FCFF adjusts CFO to exclude any cash outflows from interest expense. It ignores the tax benefit of interest expense and subtracts capital expenditures from CFO. This is the cash flow figure used to calculate cash flows in a DCF. It represents cash during a given period available for distribution to all providers of capital.
The advantage over CFO is that it accounts for required investments in the business, such as capex (which CFO ignores). It also takes the perspective of all capital providers instead of just equity owners. In other words, it identifies how much cash the company can distribute to providers of capital regardless of the company’s capital structure.
EBITDA vs. Cash Flow from Operations (CFO) vs. Free Cash Flow (FCF)
EBITDA, for better or for worse, is a mixture of CFO, FCF, and accrual accounting. First, let’s get the definition right. Many companies and industries have their own convention for calculating of EBITDA (they may exclude non-recurring items, stock-based compensation, non-cash items other than D&A, and rent expense). For our purposes, let’s assume we’re just talking about EBIT + D&A. Now let’s discuss the pros and cons.
1. EBITDA takes an enterprise perspective (whereas net income, like CFO, is an equity measure of profit because payments to lenders have been partially accounted for via interest expense). This is beneficial because investors comparing companies and performance over time are interested in the operating performance of the enterprise irrespective of its capital structure.
2. EBITDA is a hybrid accounting/cash flow metric because it starts with EBIT — which represents accounting operating profit, but then makes a non-cash adjustment (D&A) while ignoring other adjustments you’d typically see on CFO such as changes in working capital. See how Constant Contact (CTCT) calculates its EBITDA and compares it to its CFO and FCF.
The bottom line result is that EBITDA is a metric that somewhat shows you accounting profits (with the benefit of it showing you ongoing profitability and the downside of it being manipulable) but at the same time adjusts for one major non-cash item (D&A), which gets you a bit closer to actual cash. So, it tries to get you the best of both worlds (and the flip side is that it retains the problems of both, as well).
Perhaps the biggest advantage of EBITDA is that it is used widely and is easy to calculate.
Case in point: Say you are comparing the EBITDA for two identical capital-intensive businesses. By adding back D&A, EBITDA prevents different useful life estimates from affecting the comparison. On the other hand, any differences in revenue recognition assumptions by management will still skew the picture.
Where EBITDA also falls short (compared to FCF) is that if one of two capital-intensive businesses are investing heavily in new capital expenditures that are expected to generate higher future ROICs (and thus justify higher current valuations), EBITDA, which does not subtract capital expenditures, completely ignores that. Thus, you may be left incorrectly assuming that the higher ROIC company is overvalued.
3. EBITDA is easy to calculate: Perhaps the biggest advantage of EBITDA is that it is used widely and is easy to calculate. Take operating profit (reported on the income statement) and add back D&A, and you have your EBITDA. Furthermore, when comparing forecasts for EBITDA, CFO, FCF (as opposed to calculating historical or LTM figures), both CFO and FCF require an analyst to make far more explicit assumptions about line items that are challenging to accurately forecast/predict, like deferred taxes, working capital, etc.
4. EBITDA is used everywhere, from valuation multiples to formulating covenants in credit agreements. It is the de facto metric in many instances, for better or for worse.