Why EBITDA is Not Cash Flow

There is a misconception in corporate finance that EBITDA (Earnings Before Interest, Depreciation, and Amortization) is synonymous with cash flow. The metric gained prominence with the arrival of the LBO industry in the 1980’s as buyout firms used it to estimate how much debt a company could take on, a key component of the LBO strategy. As standardized as EBITDA has become in company valuation – purchase prices and loan covenants are often quoted as multiples of EBITDA – the metric is not uniformly defined under GAAP standards and its calculation varies from company to company, leading to disparities and misunderstandings about the true cash-generative abilities of a business.

EBITDA does not take into account any capital expenditures, working capital requirements, current debt payments, taxes, or other fixed costs which analysts and buyers should not ignore. The cash needed to finance these obligations is a reality if the business wishes to grow, defend its position, and maintain its operating profitability.

Here are three costs that are not included in the EBITDA calculation and by omitting tends to overstate operating cash flows:

Capital Expenditures

Certain industries like heavy manufacturing, shipping, aviation, telecom, clean technology and oil and gas require heavy ongoing or up front investments in equipment. EBITDA does not take into account capex, the line item that represents these significant investments in plant and equipment. Ignoring capital expenses to inflate EBITDA by $3.8B precipitated the bankruptcy of WorldCom. Essentially, the company capitalized operating expenses, allowing them to be depreciated over time, thus decreasing operating expenses and boosting EBITDA.

Depreciation

“The biggest problem I encounter is an over or underestimation of capital expenses for asset-heavy companies such as trucking. Adding back all depreciation for a company like this without leaving an allowance for capex can grossly overestimate the available cash flow. However, not adding back any depreciation can underestimate the cash flow, especially if the company uses accelerated depreciation,” advises GWF's Research & Analytics specialists. There have been more insidious cases of companies manipulating depreciation schedules to inflate EBITDA, such as Waste Management in the mid-nineties extending the useful lives of its garbage trucks and overstating their salvage value.

Working Capital Adjustments

Businesses need to invest revenue back into the company to keep expanding. EBITDA does not account for changes in working capital (current assets minus current liabilities) and the cash required to run the daily operating activities. Ignoring working capital requirements assumes that a business gets paid before it sells its products. Very few companies operate this way. Most businesses provide a service and get paid in arrears. Ideally a business collects up front for its services and pays in as much time as possible to remain as liquid as possible and to quickly reinvest cash into profitable investments like inventory purchases. This relationship between sources and uses of cash speaks to a company’s ability to take on more projects such as higher debt payments in the case of an LBO.

While EBITDA is useful in that it allows for a back-of-the-envelope comparison of two companies with similar business models or in the same industry, a 2000 letter to Berkshire Hathaway shareholders written by Warren Buffet put EBITDA in its place: “References to EBITDA make us shudder…We’re very suspicious of accounting methodology that is vague or unclear, since too often that means management wishes to hide something.”

David Simmons at Forbes magazine once called EBITDA the “device of choice to pep up earnings announcements.” It does not exist in a vacuum and is irrelevant on a standalone basis. It does help when comparing similar companies under time constraints, but is by no means a thorough valuation tool when making an important investment decision.

Types of Cash Flow

Operating Cash Flow

In financial accounting, operating cash flow (OCF), or cash flow from operating activities (CFO), refers to the amount of cash a company generates from the revenues it brings in, excluding costs associated with long-term investment on capital items or investment in securities. The International Financial Reporting Standards defines operating cash flow as cash generated from operations less taxation and interest paid, investment income received and less dividends paid gives rise to operating cash flows. To calculate cash generated from operations, one must calculate cash generated from customers and cash paid to suppliers. The difference between the two reflects cash generated from operations.

Free Cash Flow

In corporate finance, free cash flow (FCF) or free cash flow to firm (FCFF) can be calculated by taking operating cash flow and subtracting capital expenditures. It is a method of looking at a business's cash flow to see what is available for distribution among all the securities holders of a corporate entity. This may be useful to parties such as equity holders, debt holders, preferred stock holders, convertible security holders, and so on when they want to see how much cash can be extracted from a company without causing issues to its operations.

Discounted Cash Flow

In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted by using cost of capital to give their present values (PVs). The sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.