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".
Distinctions between EBITDA, Operating Cash Flow and Free Cash Flow
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.
Calculating EBITDA
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
Take a look at this photo breaking down EBIDTA from
***For advanced readers: it will also exclude stock based compensation in most instances since this is a non-cash charge**
Strengths of EBITDA
Why do we prefer EBITDA over Net Income to gauge the strength/weakness of the firm?
- In general, it is a much stronger indicator of ongoing, operational strength for the firm.
- 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).
- 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.
- 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.
- 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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What are Operating Cashflows?
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:
- 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.
- 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.
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Uses of Free Cash Flows
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.
Read More About EBITDA On WSO
- Which Taxes Should I Add Back To EBITDA?
- EBITDA Ambiguity - If EBITDA Excludes Depreciation And Amortization, Why Do We Subtract D And A From It To Get EBIT?
- What Is Earnings Before Interest, Tax, Depreciation & Amortization (EBITDA)?
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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
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:
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.
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
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.