EBITDA and Cash Flow – What’s the Difference?

January 14, 2016

Share on:

It’s common to hear people talk about the value of a business in multiples of EBITDA. While this can be useful, it’s important not to confuse EBITDA with cash flow.

Calculator

What is EBITDA? In simple terms, it is an acronym for “Earnings Before Interest, Taxes, Depreciation and Amortization”. EBITDA is a useful basis to value a company because it provides some common ground to evaluate a company’s earnings. Earnings vary depending on how much debt it has, what tax rate it pays, and policies related to the depreciation and amortization of assets.

EBITDA is not always easily understood, and its calculation varies from preparer to preparer. Reliance on the stated EBITDA can lead to a misunderstanding of the actual cash generated by a business.

While we need to evaluate EBITDA as a starting point, it is important to understand that it does not take into account the working capital required to operate a company, capital expenditures, required debt repayments and, of course, income taxes that must be paid. The cash required to finance these activities cannot be ignored if a company wants to grow and maintain profitability. To calculate cash flow, these items are deducted from EBITDA.

There are common mistakes made when analyzing the equity value of a business:

  • Under-estimating the ongoing or immediate need to purchase or replace equipment. Start by looking at the quality of assets and do some research on when they need to be replaced.
  • Ignoring the amount of working capital required to operate a business. Businesses need to retain revenue to finance inventory, accounts receivable and daily operating expenses. The balance sheet presented to you might not represent the working capital that is actually required to operate the business throughout the normal annual business cycle.

You should always be interested in hearing about EBITDA, but you must develop an understanding of the future cash flow. This includes consideration of the following:

  • How is EBITDA calculated and does it make sense?
  • Is EBITDA maintainable?
  • What are required and long-term capital expenditures?
  • How much working capital is required throughout the annual and business cycles?
  • How do you finance predicted growth?
  • How much income tax will you have to pay?

These questions can be answered with some research and a review of historical financial records. While EBITDA is interesting, it’s cash flow that ultimately matters.





Ask Us a Question

Sign up to receive our newsletter