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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.

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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.

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Comments (46)

  • dagobert_duck's picture

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

  • jhoratio's picture

    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.

  • squawkbox's picture

    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
    wkc207's picture

    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?

  • hungry's picture

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

  • squawkbox's picture

    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.

  • jaclee317's picture

    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.

  • jimbrowngoU's picture

    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.

  • icandoit's picture

    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
    MezzKet's picture

    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 icandoit
    squawkbox's picture

    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

  • squawkbox's picture

    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.

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  • jhoratio's picture

    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.

  • In reply to icandoit
    killscallion's picture

    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.

  • icandoit's picture

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

  • UncleKevin's picture

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

  • rmivalue's picture

    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.

  • squawkbox's picture

    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.

  • hujja's picture

    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
    squawkbox's picture

    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.

  • zoomi's picture

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

  • DebunkingMyths's picture

    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
    squawkbox's picture

    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

  • In reply to Boothorbust
    squawkbox's picture

    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?

  • Boothorbust's picture

    ^ 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
    squawkbox's picture

    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!

  • DebunkingMyths's picture

    EBITDA not good proxy if you have large NWC.

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

  • DebunkingMyths's picture

    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
    squawkbox's picture

    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.

  • In reply to DebunkingMyths
    squawkbox's picture

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  • In reply to Tomas-Vacek
    Matrick's picture

    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