EBITDA is often used and confused as an approximation of cash flow. Many business professionals (CPAs, business owners, bankers, attorneys and others) struggle to understand the differences between EBITDA and cash flow from operations within a business. Below are some differences between these business metrics.
“EBITDA” is defined as net income (earnings) with interest, taxes, depreciation,
“Operating Cash Flow” or “OCF” is (in accounting) a measure of the amount of cash generated by a company's normal business activities. Operating cash flow is important because it indicates whether a company generated sufficient positive cash flow to maintain and grow its operations, or whether it may require external financing. OCF is calculated by adjusting net income for non-cash items such as depreciation and also changes to working capital balances such as accounts receivable, inventory and account payable. The operating cash flow statement is typically included in the U.S. GAAP based financial statements and sometimes referred to as the “indirect direct” method of cash flows.
The table below compares EBITDA to OCF. A 3rd column is presented for discussion purposes:
EBITDA is widely used and is easy to calculate by taking income from operations (reported on the income statement before interest and taxes) and adding back depreciation and amortization (reported as a line item or items in the cash flow statement).
EBITDA is used almost everywhere, from valuation multiples to bank covenant calculations in credit agreements.
EBITDA allows you to compare the profitability of different companies by cancelling the effects of a company’s capital, financing and tax entity structure. It is the “standard” metric in the business community.
But keep in mind the EBITDA does not equal cash flow. The most obvious shortfalls of the EBITDA calculation as a measure of cash flow are that EBITDA does not (1) consider the increase (or decreases) in working capital accounts that may fluctuate with a business as it grows (shrinks) and (2) it does not subtract capital expenditures that are needed to support production, especially in a manufacturing environment.
In the table above, Operating Cash Flow (“OCF”) does a better job of adjusting for the increasing working capital needs of a growing company. But OCF fails to add back interest expense and income tax expense. Adding back these items make it easier to compare businesses with different capital or tax structures.
As presented in Column 3, I would argue that we should also include capital expenditures in the evaluation of the operations of a company. Capital expenditures are necessary to support and grow production. Capital expenditures may have a significant impact on cash flow if the business has a need for expanded capacity or updates to its equipment.
In conclusion, EBITDA is, and will probably always be, the key business metric for evaluating the performance of a business. However, keep in mind that EBITDA is not cash flow and that many other factors should be considered.
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This article was co-authored by John Nicklas and Abbey Cigoi.