1/19/13

Moderator note (Andy): this is a post from 2010 but squawkbox suggested its relevancy remains and can be very useful for those going through FT & SA interviews. "Don't beat it to hell because it's missing some small details, but it's good for what someone will need in the "hotseat" during the technical part of the interview".

Noticed EBITDA has been a common source of confusion. I hope this helps anyone with SA or FT interviews coming up. I left out some of the minutiae to keep it as relevant as possible.

----------------------------------------------
EBITDA = Earnings Before Interest Taxes Depreciation and Amortization

EBITDA = Operating Income + Depreciation + Amortization
= EBIT + Depreciation + Amortization
= Net Income + Income Tax Expense + Interest Expense + Depreciation + Amortization

***For advanced readers: it will also exclude stock based compensation in most instances since this is a non-cash charge**

Why do we prefer EBITDA over Net Income to gauge the strength/weakness of the firm?

1) In general, it is a much stronger indicator of ongoing, operational strength for the firm.
2) Taxes are considered "non-operational" in a sense because they can be affected by a variety of accounting and tax conventions. These have no bearing on the ongoing, operational strength of the firm. Companies with significant losses in the past will have "artificially" low taxes rates once they become profitable due to something called NOLs (e.g. Biotechs, Technology co's).
3) Interest expense is a function of leverage, not operations. Companies in any given industry will have varying degrees of interest expense based on the debt load they incur.
4) Depreciation expense is an accounting convention based on the PP+E of the firm. It has no bearing on the ongoing operational strength of the firm. Firms with high capital requirements (manufacturing, autos, retail, aircraft builders, airlines, transports) will have very high depreciation expense due to the nature of the assets they hold. We need to take depreciation "out" in order to see how the firm's operations actually performed in a given year
5) Amortization expense is another accounting convention dealing with the amortization of intangibles. Because it is an accounting convention, we want to take it "out" also. Companies with significant intangible assets on their balance sheets will have material amortization expenses reducing operational income. These usually result from acquisitions.

--------------------------------------------------------
Cash Flow from Operations (CFO/OCF)

CF from Ops
= Net Income + Depreciation + Amortization - Chg in Non Cash Current Assets(Inventory, A/R) + Chg in Non Debt Current Liabilities(A/P, Deferred Revs) + Non-Cash Items
= Net Income + Depreciation + Amortization - Chg Non Cash Working Capital + Non-Cash Charges

Why do we need Cash Flow from Operations when we already have EBITDA?

The key OPERATIONAL distinction between EBITDA and CFO/OCF is the Change in Net Working Capital. CFO/OCF are also burdened by taxes and interest expense.

Both will usually exclude the non-cash, one-time items.

There are many operational factors which come into account in the Change in Net Working Capital:

a) Deferred Revenue --> there are certain products and services a company can sell which will not show up in the traditional revenue account on the income stmt. A great example is the iPhone. Apple can only recognize (3/24) of the revenue of each iPhone they sell in a given quarter. As a result, EBITDA and Net Income are severely understated if we want to know Apple's operational performance for a given time period. However, the remainder of the revenue shows up in the Operating Section of the Cash Flow Statement. Compare Apple's Net Income to their Cash Flow from Operations to see the effect.

b) Operational Efficiency --> one example is inventory management. If a company needs more inventory, then that will require spending cash that could be put to other uses. This means that the current asset, inventory, goes up and "uses" cash. Another example is credit policy. What would be preferable, a company which only takes cash or one that allows you to push off payment for a year @ 0% interest. If a company records $100 of revenue but does not collect cash, then accounts receivable (current asset) will rise and "use" cash.

--------------------------------------------------------
Free Cash Flow (FCF)

Unlevered FCF = Free Cash flow to Firm (FCFF) = EBIT(1-T) + D&A - Change in NonCash WC - CAPEX

The FCFF represents the cash flows available to ALL investors after mandatory cash outflows for business needs have been taken out (including taxes).

The reason we need FCF instead of EBITDA and OCF is the CAPEX adjustment. Any capital intensive company will be spending money on a regular basis to buy/modify/upgrade/replace their fixed assets (stores, machines, equipment, airplanes). Capex can represent a significant reduction in cash flow for many of these companies. Look at the Cash Flow Statement for any of the airlines to see the effect. Capex is an ongoing, operational cash outflow that must be considered.

Comments (67)

Best Response
1/7/10

Reramos,

Say there's an apartment building that's "worth" $100,000. It has a $60,000 30-year mortgage on it, leaving $40,000 of equity in the building. Let's say it generates $7,000 of rent annually. The annual interest and principal on a 30-year loan of 60K at 5% interest is about $3,865. Add $2000 in annual capital expense and our very simplified example clears about $1100 annually. Now here comes Mr. LBO man thinking he can do better. He buys the house with a loan for $98000 and 2000 of his own money. The annual payment on this loan is $6313. No matter, 7000 in rent covers it, but the annual capital expense will have to wait. That roof can hold out for another year or five. After five years, the present value of the loan is about $90,000 and the house is still "worth" $100,000. Let's assume that rents went up a bit over 5 years so the cash stream is a bit more valuable. Therefore equity now is $10,000. At this point, LBO man sells the house, pays off the loan, and goes home with $10,000. Turning $2000 into $10,000 over 5 years represents an IRR of 38% which he can brag to his friends about. The guy who bought the house from LBO man is not so lucky - the next year the roof caves in from neglect and all his tenants leave. The LBO guy may seem like a genius to his limited partners, but all he has done is taken full advantage of the available borrowing base and paid himself the five years worth of capital expense. LBO shops are not out to operate businesses but to create a high return for their investors. Remember, it was the companies that failed. The LBO shops that created the mess didn't fail at all - on the contrary they did just fine.

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1/6/10

Net working capital is inventory plus receivables minus payables instead of the difference between current assets and current liabilities.

1/6/10

I have an issue with your statement "depreciation is an accounting convention." Obviously that is true, but it's not like the numbers are just made up. They represent real cash having gone out the door. Unless the business has invented some new trick to make everything they own last forever - bet on them having to continue investing in the company. The best way to approximate what this ongoing "expense" would be? Depreciation. Looking at EBITDA and coming away that this is what cash flows "should be" is completely erroneous, because future capital expenditures will continue to require cash, often lots of it.

1/6/10

I completely agree that you have to take depreciation into consideration for the long run. Leaving room for a D+A allowance is essential. Many of the 1980's LBOs failed because they erroneously thought they could replace capex/depreciation with interest.

However, if you want to see solely how a company's operations did in a given year, then D+A is irrelevant.

Nevertheless, if you still want to take depreciation into account, it's better to do so via Free Cash Flow. The current year's capex spending is more relevant than the current year's depreciation expense.

S/T Operational Performance --> EBITDA
L/T Overall Performance --> Free Cash Flow

In reply to squawkbox
1/6/10
squawkbox:

I completely agree that you have to take depreciation into consideration for the long run. Leaving room for a D+A allowance is essential. Many of the 1980's LBOs failed because they erroneously thought they could replace capex/depreciation with interest.

However, if you want to see solely how a company's operations did in a given year, then D+A is irrelevant.

Nevertheless, if you still want to take depreciation into account, it's better to do so via Free Cash Flow. The current year's capex spending is more relevant than the current year's depreciation expense.

S/T Operational Performance --> EBITDA
L/T Overall Performance --> Free Cash Flow

Thanks very much for the post, it is extremely helpful for a Junior like myself looking for SA..

Just a very rookie question, how come deffered revenue is included in current libilities? shouldnt it be seen as similar to accounts receivable and placed in current assets?

1/6/10

"deferred" or unearned revenue is a liability because services have yet to be rendered. Once they are a corresponding expense is incurred.

1/6/10

The classic example of deferred revenue is "Unearned Rent".

Let's assume you pay your landlord (a publicly traded apartment REIT) for a year of rent in advance ($1200).

Since he has not actually delivered his product to you yet, he cannot recognize the $1200 as "revenue". In essence, you have made a short term "current" loan to your landlord. He debits cash $1200 and credits deferred revenue (a liability) by $1200 -- so the books balance.

Each month you live there, he can recognize "one month's" worth of rent ($100).

So in a given quarter he can recognize 3 month's worth of revenue ($300). He would debit the liability and credit his equity revenue account.

1/6/10

Yes, depending on your accounting class/text, you might have seen it as a Customer Advances account instead of Unearned Revenue. Same thing. You got the money now, but you didn't "earn" the sale yet by providing the good/service. Just an accrual accounting concept.

1/6/10

Think of it this way (this may be a helpful way to understand assets and liabilities as uses and sources of cash): You receive cash in advance, but cannot book it as revenue because services or goods have not been performed or delivered. Because of this, there is no reflection of this received cash on the statement of cash flow (revenue flows thru to net income, which starts off the CF). But you need to reflect the cash somehow -- so you create a liability account called deferred revenue and increase this account. This increase in liability will be reflected on the cash flow as a source of cash.

I just think it helps make the sometimes difficult concept of A&L as S&U of cash a bit more intuitive.

1/7/10

squawkbox, Thanks very much for posting this!

Just need a quick confirmation, the FCF formula is for the levered FCF, right? I believe for the unlevered FCF, we use EBIT(operation income)+ D&A - change in working capital- CAPEX. Also, the levered FCF depends on the capital structure while the unlevered FCF is capital structure neutral. Please correct me if I'm wrong...

In reply to squawkbox
1/7/10
squawkbox:

I completely agree that you have to take depreciation into consideration for the long run. Leaving room for a D+A allowance is essential. Many of the 1980's LBOs failed because they erroneously thought they could replace capex/depreciation with interest.

However, if you want to see solely how a company's operations did in a given year, then D+A is irrelevant.

Nevertheless, if you still want to take depreciation into account, it's better to do so via Free Cash Flow. The current year's capex spending is more relevant than the current year's depreciation expense.

S/T Operational Performance --> EBITDA
L/T Overall Performance --> Free Cash Flow

That's exactly why LBOs calculate Fixed Cover Charge ratios and utilize EBITDA - CAPEX... EBIT can be done but this assumes that the assets are replaced dollar for dollar as they wear out... EBIT can be manipulated by the accounting treatment you use on the depreciation which isnt necessarily indicative of replacement capex, just fidgiting with accounting treatments to minimize / maximize taxes...

That's why when we look at heavy capex businesses, all leverage and purchase multiples are done off of EBITDA - CAPEX... Clearly FCF is the ideal method but the assumptions warp the accuracy even further... the less assumptions needed to achieve that number, the more accurate / reliable it can be, in my experience...

In reply to sailingboat
1/7/10
icandoit:

squawkbox, Thanks very much for posting this!

Just need a quick confirmation, the FCF formula is for the levered FCF, right? I believe for the unlevered FCF, we use EBIT(operation income)+ D&A - change in working capital- CAPEX. Also, the levered FCF depends on the capital structure while the unlevered FCF is capital structure neutral. Please correct me if I'm wrong...

Levered FCF = Free Cashflow to Equity (FCFE) = Net Income + D&A - Change in NonCash Working Capital + Net Change in Debt Load - Capex

Unlevered FCF = Free Cash flow to Firm (FCFF) = EBIT(1-T) + D&A - Change in NonCash Working Capital - Capex

To answer your question, yes the FCF I used in the first post was Levered FCF. However, in interviews, use the unlevered FCF when asked to do a DCF (Discounted Cash Flow Model). I went ahead edited it to be the unlevered.

The key element is remember is that FCFF and FCFE take capex into account, whereas the others (EBITDA, CF from Ops) do not.

Levered FCF --> certainly depends on capital structure

Unlevered FCF --> does not depend on capital structure

In reply to MezzKet
1/7/10

Could you further explain the whole LBO mistake of the 1980's and the ratio discussed? I don't get it, but I want to understand it.

1/7/10

EBITDA = Earnings/Cash flow available before interest, taxes, depreciation, and amortization

You (the company) have control over D+A and the interest expense. Taxes are a percentage of the remainder.

Let's say that the company, an airline, purchases a plane today for $500 million cash. This is capex.

Assume that the plane will last 5 years, and the company will need to purchase another one at that time using cash.

Assume the company does $100m of EBITDA each year. An aggressive LBO buyer will come in and borrow to the extent that he is incurring $100m of interest expense each year. He essentially is taking all of the cash from EBITDA to pay for debt. As a result, no cash is being "saved" for future capex.

At the end of the 5th year, the plane is useless and the company needs to buy another. But it can't because all of its EBITDA cash flow has been used for interest.

The company does not have a plane and therefore, does not have a business. The company goes bankrupt.

On the other hand, if the company had zero interest expense, then the EBITDA would have been saved as a "depreciation allowance". At $100m a year for five years, the company would have $500m in cash by the time the plane died and could have purchased another.

In reply to jhoratio
1/7/10

So, this is what happened in the 1980 LBO craze? Alot of private equity firms took advantage of companies with steady cash flows?

1/7/10
In reply to sailingboat
1/7/10
icandoit:

squawkbox, Thanks very much for posting this!

Just need a quick confirmation, the FCF formula is for the levered FCF, right? I believe for the unlevered FCF, we use EBIT(operation income)+ D&A - change in working capital- CAPEX. Also, the levered FCF depends on the capital structure while the unlevered FCF is capital structure neutral. Please correct me if I'm wrong...

Don't forget cash taxes.

1/8/10

thanks for your explanations, squawkbox and killscallion. They were very helpful!

1/25/10

Solid Post. Will def come up in interviews. Really understand EBITDA for IB analyst class!

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1/25/10

Goodwill no longer amortized (GAAP 2001, IFRS 2005) but is annually tested for impairment loss.

(not all) Intangibles are amortized over estimated useful economic lives and GAAP/IFRS schedules.

2/9/10
2/9/10

EBITDA is used for multiples and such. FCF is what you really want to know. I mean when it all comes down to it, what kind of cash is coming after you pay taxes, interest, etc. A wise man told me once " Accounting is Vanity, Cash is Sanity"

2/9/10

why is EV/EBITDA so much more common than EV/FCF? its also unlevered so its still apples to apples

2/9/10

I will let wiser people answer that. I am sure there are more concise answers to your original question also.

My educated guess towards your "why is EV/EBITDA more common" is basically EBITDA is a even starting point for most companies. If you have a high depreciation then it will reduce your taxes paid and increase FCF.

2/10/10

EBITDA is really just meant to be a short-form proxy for cash flow. FCF takes into account a number of adjustments that vary from company to company and can be more time-intensive to tease out of the filings (i.e. require capex, amortization of debt principal, etc.).

I use EBITDA when I care about a quick and dirty comparison between companies for valuation/credit metrics. If you're actually going through a credit underwrite, FCF will be much more important.

For example, the major credit agencies will use Debt/EBITDA in their factor analysis, but they also use FCF/EBITDA in order to tell a company's true ability to generate cash.

2/10/10

capex can be very lumpy for a lot of companies depending on their capital budgeting needs. EBITDA is thought of as more normalized for operations, but FCF is the real cash flpw #. When comparing companies, EBITDA is probably more prevalent because you can't easily normalize capex spend other than not include it in the first place.

2/10/10

FCF is actually levered (net income + D&A - change in WC - capex). You can unlever it for a DCF, but standard FCF is levered.

EBITDA is used because it's a "quick and dirty" cash flow number -- essentially, a proxy for cash flow. You generally look at multiples on a forward basis, and in trying to predict FCF, you would have to make assumptions around capex and changes in WC going forward -- this is something you are unlikely to have to insight to do, and it would be all over the board for companies. How would you estimate WC? How about capex? Using EBITDA helps "standardize" across the board for comps.

2/10/10

EBITDA is before interest and taxes, so it removes the effects of leverage from a company, therefore showing the "earnings potential" of a company on an unlevered basis. The value here is that if you are looking at two similar companies in the same industry, which may be levered at different levels, that leverage is considered discretionary in many circumstances. Because the theoretical earning power could be the same for both companies, but leverage could create the appearance of lower earnings via a larger interest expense, EBITDA is used to show an "apples to apples" comparison across firms. Let me illustrate through a brief example

Company A:
Net income 500
COGS 200
SG&A 50
Deprec 25
EBIT 225
Interest 100
EBT 125

Company B:
Net income 500
COGS 200
SG&A 50
Deprec 25
EBIT 225
Interest 10
EBT 215

Clearly these companies are the same excluding leverage choices, illustrated by the same EBIT number, but EBT is significantly lower for the higher levered company (company a), which would in turn result in lower taxes (EBT * tax rate = int tax exp), so in order to show a comparable leverage free earning power, we look to EBITDA to provide an "earnings potential" of a company.

2/10/10

EBITDA is used more for comparisons but FCF is much more accurate.

Capex does not show up in EBITDA. You can pump up future EBITDA by increasing capex today with no penalty to today's EBITDA. Free lunch right? Free cash flow gives you the true picture.

At the end of the day, you need to learn and understand how a DCF works using FCF.

11/19/10

bump for you prospective SAs

I haven't edited it since I started on the desk, but it looks as applicable as it did a year ago.

11/20/10

Assuming the indirect method of setting up a CF statement, isn't unlevered FCF simply =NI+ CF from Operations + CF from Investing?

Also just wanted to point out that the CF from Operations formula should also include + losses/-gains on sale of non-current assets.

Awesome topic. Keep it up WSO!

In reply to hujja
11/20/10
hujja:

Assuming the indirect method of setting up a CF statement, isn't unlevered FCF simply =NI+ CF from Operations + CF from Investing?

Also just wanted to point out that the CF from Operations formula should also include + losses/-gains on sale of non-current assets.

Awesome topic. Keep it up WSO!

You would never use NI or CFO as a starting point for deriving uFCF. You need EBIT and then tax affect the EBIT.

You are correct about the non-current assets. I left certain things out to keep it simple enough to be effective in an SA interview. Remember that SA interviews and FT interviews for non-finance majors are not hyper technical. Finance majors should know every detail of this material.

12/28/11

ebitda is a proxy, sometimes it can be a very bad proxy when dealing with capital intensive companies

cash flow i take it you are talking about what's on the financial statements, it's more comprehensive but often times not needed and you can't really predict the other line one time items

free cash flow is ebitda - cash tax - cash interest - change in working cap - capex, this tells you basically everything you need to know about the cash of the company unless some one-time event happens (issues more bond..repay more loan, etc)

12/28/11

The complete answer is actually not trivial.

First, let's look at cash from operations (CFO). The main advantage of CFO is that tells you exactly how much cash a company generated from operating activities during a period. Starting with net income, it adds back noncash items like D&A and captures changes from working capital. Here is Wal Mart's CFO.

This is an extremely important metric, so much so that you might wonder what's the point of even looking at accounting profits (like Net Income or EBIT, or to some extent EBITDA) in the first place. I wrote a blog post about this recently Net Income vs Cash Flows, 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, Boeing's operating profits show a much more accurate picture of profitability (since the accrual method used for calculating net income matches revenues with costs).

Of course, 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 judgement and estimates, the income statement is very sensitive to earnings manipulation and shenanigans. Two identical companies can have very different looking income statements if the two companies make different (often arbitrary) deprecation assumptions, revenue recognition, and other assumptions.

So, the benefits of CFO are that it is objective. It is harder to manipulate CFO than accounting profits (although not impossible since companies still have some leeway in whether they classify certain items investing, financing, or operating activities, thereby opening the door for messing with CFO). The primary downside is the flip side of that coin - namely, you don't get an accurate picture of ongoing profitability.

Free cash flows vs operating cash flows
Now let's talk about the other cash flow metric you were asked to compare - free cash flows. 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 probably the one investment bankers use most often (unless it is a FIG banker in which case she will be most familiar with FCFE).

FCFF adjusts CFO to exclude any cash outflows from interest expense, ignores the tax benefit of interest expense, and subtracts capital expenditures from CFO. This is the cash flow figure that is 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 like capex (which CFO ignores) and it also takes the perspective of all providers of capital 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 CFO and 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 it 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 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 one non cash adjustment - D&A - but ignores other adjustments you would typically see on CFO, like changes in working capital. See how Constant Contact's (CTCT) calculates its EBITDA and compare to its CFO and FCF

The bottom line result is that you have a metric that somewhat shows you accounting profits (with the benefit of it showing you ongoing profitability and the cost of being manipulatable) but at the same time adjusts for one major noncash item - the D&A which gets you a little closer to actual cash. So - it tries to get you the best of both worlds (the flip-side is it retains the problems of both as well).

Case in point: say you are comparing EBITDAs 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 would still skew the picture. Where EBITDA also falls short (compared to FCF) is that if one of the 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, and you may be left incorrectly assuming that the higher ROIC company is overvalued

3. It is easy to calculate: Perhaps the biggest advantage of EBITDA might very well be that it is used widely and it is easy to calculate. Take operating profit (reported on the income statement) and add back D&A and you have your EBITDA. Further, when comparing forecasts for EBITDA, CFO, FCF (as opposed to calculating historical or LTM figures), both CFO and FCF requires an analyst to make far more explicit assumptions about line items that are challenging to predict accurately, like deferred taxes, working capital, etc.

Lastly, EBITDA is used everywhere from valuation multiples to formulating covenants in credit agreements, so it is the de facto metric in many instances for better or for worse.

Matan Feldman
Founder, Wall Street Prep
Learn Financial Modeling

12/29/11
1/17/12

Which method do most companies use in preparing the CF Statement:: Direct or Indirect? Can someone explain the difference?

1/17/12

Depends on where the company is. Chinese companies all use direct, they add up all the items. Sometimes they will show both (in the appendix they will reconcile)

In reply to zoomi
1/17/12
zoomi:

Which method do most companies use in preparing the CF Statement:: Direct or Indirect? Can someone explain the difference?

Indirect !!!!

Not even worth explaining the difference

1/17/12

Can someone clarify why we can't start with CFO and add back taxes and interest, rather than use EBITDA?

In reply to Boothorbust
1/17/12
Boothorbust:

Can someone clarify why we can't start with CFO and add back taxes and interest, rather than use EBITDA?

CFO is impacted by the change in Net Working Capital (NWC)

If you have a rapidly growing retail firm, they will be steadily adding to inventories. This increases NWC and reduces OCF.

It is a relevant cash outflow since the growth of the firm will be tied to these changes in working capital.

Does that make sense?

1/17/12

^ This makes sense, but suggests to me that we SHOULD be using CFO to calculate cash flows available to the firm, since it strips out changes in NWC. If I'm doing a DCF then, why shouldn't I use CFO, plus interest and taxes? Seems like CFO with these adjustments is a better measure of true cash flows. I guess my queston is, what is the difference between
EBITDA -/+ changes in NWC - capex
and
CFO + interest + taxes - capex

Why do we use EBITDA as the starting point to calculate FCF?

In reply to Boothorbust
1/17/12
Boothorbust:

^ This makes sense, but suggests to me that we SHOULD be using CFO to calculate cash flows available to the firm, since it strips out changes in NWC. If I'm doing a DCF then, why shouldn't I use CFO, plus interest and taxes? Seems like CFO with these adjustments is a better measure of true cash flows. I guess my queston is, what is the difference between
EBITDA -/+ changes in NWC - capex
and
CFO + interest + taxes - capex

Why do we use EBITDA as the starting point to calculate FCF?

There is a tax shield from the depreciation and amortization...hence EBIT(1-T).

By deducting D&A, you have lower EBIT, so you pay lower taxes.

Example:

EBITDA: $1000

EBIT: $500

Tax rate is 50%

Assume no interest expense.

If depreciation and amortization were NOT tax-deductible, then you would pay 50% * $1000 = $500 in taxes

However, since they are deductible, we only pay 50% * $500 = $250 in taxes

They (D&A) provide a nice tax shield.

The IRS only accepts USD to pay taxes, so this is very relevant in a DCF.

Great question!

1/17/12
1/18/12

EBITDA not good proxy if you have large NWC.

Some people do use NI and just work backwards ... its the same sht -

1/18/12

Squawkbox, most companies in the US and Europe do use indirect but if you work on any cross border deals, plenty of companies use direct ...(into Asia for example)

I've been given model tests where I had to reconcile a direct cash flow statement .... so don't "not worth metion" it

In reply to DebunkingMyths
1/18/12
DebunkingMyths:

Squawkbox, most companies in the US and Europe do use indirect but if you work on any cross border deals, plenty of companies use direct ...(into Asia for example)

I've been given model tests where I had to reconcile a direct cash flow statement .... so don't "not worth metion" it

The point of this thread, and my others, are to give general resume and interview advice to prospective SAs and FTs.

They do not need to know about the direct method of cash flow statements for an interview. You might be right, but this site is for prospectives NOT practitioners.

1/18/12

Isn't it better to know both from the get-go than to formulate an inaccurate view from the getgo?

/justsaying

In reply to DebunkingMyths
1/19/12
DebunkingMyths:

Isn't it better to know both from the get-go than to formulate an inaccurate view from the getgo?

/justsaying

No, the direct method of cash flow statements is useless for the vast majority of banking, so why should prospectives bother to waste the sheer amount of time needed to learn it?

In reply to Boothorbust
1/19/12
Boothorbust:

^ This makes sense, but suggests to me that we SHOULD be using CFO to calculate cash flows available to the firm, since it strips out changes in NWC. If I'm doing a DCF then, why shouldn't I use CFO, plus interest and taxes? Seems like CFO with these adjustments is a better measure of true cash flows. I guess my queston is, what is the difference between
EBITDA -/+ changes in NWC - capex
and
CFO + interest + taxes - capex

Why do we use EBITDA as the starting point to calculate FCF?

Because generally, you're building the model down to EBITDA yourself (not just taking the company's CFO or EBITDA number for example) and if building it down yourself, the first method is more logical.

In reply to ShreddiesBrah
1/22/12
Awon Eleyi Awon Eleyi Won Bad Gan:
Boothorbust:

^ This makes sense, but suggests to me that we SHOULD be using CFO to calculate cash flows available to the firm, since it strips out changes in NWC. If I'm doing a DCF then, why shouldn't I use CFO, plus interest and taxes? Seems like CFO with these adjustments is a better measure of true cash flows. I guess my queston is, what is the difference between
EBITDA -/+ changes in NWC - capex
and
CFO + interest + taxes - capex

Why do we use EBITDA as the starting point to calculate FCF?

Because generally, you're building the model down to EBITDA yourself (not just taking the company's CFO or EBITDA number for example) and if building it down yourself, the first method is more logical.

Agreed, there are a billion definitions of EBITDA.

You start with the components and "pick and choose" what you want to include.

For instance, a great example of MISLEADING EBITDA is Netflix. They take a huge "amortization" charge for their content library. When they buy a movie, they "amortize" the cost of the movie.

The WRONG thing to do is treat this as actual amortization, adding it back to get EBITDA. We should NOT add it back because it is an ONGOING, OPERATIONAL expense of the business.

When we properly add back amortization, it is usually for "accounting nuances". The most common of which is the amortization of intangible assets, which usually results from an acquisition. This number can be significant and material. However, it has absolutely ZERO relevance when it comes to judging the operational performance of a business. After all, the point of EBITDA is to "strip out" accrual/GAAP accounting and other non-operational metrics (taxes, interest expense).

6/18/12
1/20/13

So why so we even use EBITDA if FCF gives us a more accurate representation of a companies cash from operations?

In reply to rouda2010
1/23/13

rouda2010:
So why so we even use EBITDA if FCF gives us a more accurate representation of a companies cash from operations?

EBITDA fluctuates a lot less and is thus better suited for multiple valuation (stronger correlation to price movements)...

It also is common for it to be greater than FCF, making leverage look safer and thuse helping bankers and PE firms leverage more!

1/25/13

yes, but which one would win in a fight?

3/6/13

In response to that airplane example and that 80s LBO comment:

Depreciation is often a VERY poor proxy / doesn't accurately reflect the underlying economics. (The economic expenses associated with owning an airplane probably don't look anything like a straight line
depreciation schedule.)

NOPAT + depreciation - Capex - increase in nwc is an attempt to ESTIMATE free cash flow. The Capex estimate used in your forecast matters / impacts valuation. Why is that any more troublesome than the rest of the made up numbers in the forecast? It's an art, not a science...

Really, any gaap based recipe for free cash flow is an abstraction... We should start with NOPLAT...

8/28/13

For that D&A you would use the absolute amount for last year.

I'm talking about liquid. Rich enough to have your own jet. Rich enough not to waste time. Fifty, a hundred million dollars, buddy. A player. Or nothing.

See my Blog & AMA

10/5/14

EBITDA doesn't account for increases/decreases in cash resulting from balance sheet line items such as change in working capital, other current assets/liabilities, and other long-term assets/liabilities

10/5/14

Also the most obvious one (which I assume you identified pretty easily).... the D&A (ofc, plus the other non-cash stuff).

10/5/14

CFO is actual change in cash from operations, while the other is an imaginary, mostly BS #

10/5/14

What do you guys mean when you say D&A? As far as I see, that's a similarity not a difference (as both do not include D&A). What am I missing?

In reply to TheSanchize
10/5/14

I agree with TheSanchize. Both OCF and EBITDA are before D&A

10/5/14

Wow, the misinformation from a couple posters...

First, OCF includes items including interest and tax. As such, it is to equity holders rather than the firm. The reason is because OCF starts with net income. OCF also accounts for working capital changes. Also, people sometimes add back stock-based comp or other non-cash items to their EBITDA calc (this mostly depends on the industry standard practices), whereas you always add back all non-cash items in your OCF calc.

Further, to the point that it captures long-term assets and liabilities, that's just not true most of the time. I have seen "other long-term whatever" in OCF a couple times, but generally, long-term assets fall under investing activities and long-term liabilities fall under financing activities.

10/5/14

Holy fuck some of the first few answers are terrible. Really, you should at least have looked at a CF statement once in your life before you spread such ridiculous misinformation as "advice"

10/6/14

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