Why EBITDA and Cash Flow Are Not Synonymous

2018, 11 Jan | In Capital Transaction Planning, General Management, M & A for Entreprenuers, Merger and Acquisitions

Why EBITDA and Cash Flow Are Not Synonymous

EBITDA (Earnings Before Interest, Depreciation, and Amortization) is a standard tool in assessing a company’s valuation, ever since it started to be used as an important component of an LBO strategy in order to determine how much debt a company can handle.

Moreover, there are certain figures and numbers that aren’t factored into EBITDAs calculations, making it feasible to find disparities when trying to uncover a company’s actual valuation.

What EBITDA does not factor in

Three costs, in particular, are not included in the EBITDA calculation:

Capital Expenditures – Industries including oil and gas, telecom, shipping and aviation require a significant investment in equipment.  EBITDA does not factor in capex (the line item representing the investments in plant and equipment). If fact, ignoring capital expenses (in order to inflate EBITDA) is what preceded the bankruptcy of WorldCom.

Depreciation – When a company adds back all depreciation without providing room for capex, their cash flow will likely be overestimated. However, if a company does not add back any depreciation, the cash flow can be underestimated (particularly if the company used accelerated depreciation). Depreciation schedules have been manipulated in the past (in an effort to inflate EBITDA), such as in the 1990s when Waste Management extended the lives of its garbage trucks and thus overstating their salvage value.

Working Capital Adjustments – EBITDA does not account for changes made in working capital, which results in the assumption that a business is paid prior to selling products. However, most companies operate the same way – they provide a service or product and are compensated for it afterwards.

The fallout of relying on EBITDA

By omitting these three costs, which EBITDA does not factor in, a company’s cash flow tends to be inflated beyond its calculations. Analysts and buyers must consider fixed costs, including working capital requirements, debt payments and taxes, because if the business intends to grow and be profitable, it needs to have cash available to finance these obligations.

However, when a buyer relies on EBITDA to determine valuation, these costs are hidden. Company owners can adjust (or omit) certain calculations in order to inflate EBITDA and make their company appear to have more cash flow than it does.

EBITDA can be useful in offering loose comparisons between two companies of the same ilk.  But, when relied upon as a standard tool for assessing cash flow, it simply comes up flat.

In fact, many view references to EBITDA as a way for management to hide something or to glorify their earnings. While it may be useful, it should not be relied upon as a complete valuation tool to facilitate in the decision of an investment opportunity.