Earnings before interest, taxes, depreciation and amortization (EBITDA) is one of the most widely used performance metrics in business. Management teams often track it to evaluate results before financing and tax decisions. External stakeholders, such as investors and lenders, also may use it to assess operating performance and debt capacity. Yet EBITDA is often misunderstood — and sometimes misapplied — as a proxy for cash flow.
The Evolution of EBITDA
The market’s preoccupation with EBITDA started during the leveraged buyout craze of the 1980s. It was especially popular among public companies in capital-intensive industries, such as steel, wireless communications and cable television. Many EBITDA proponents claim it provides a clearer view of long-term financial performance than earnings, if it’s adjusted to exclude nonrecurring items and the effects of significant capital investments.
Today, EBITDA frequently appears in the “management discussion and analysis” section of public companies’ annual financial statements. Smaller, private entities also tend to use oversimplified EBITDA pricing multiples in mergers and acquisitions. And it can provide high-growth companies and start-up ventures with a convenient way to present results in a positive light before they report true profits.
Inconsistent Definitions
But what exactly does “EBITDA” refer to? It isn’t defined under U.S. Generally Accepted Accounting Principles (GAAP) and is treated as a non-GAAP measure under U.S. Securities and Exchange Commission (SEC) rules. In the absence of official guidance, companies often take liberties in adjusting EBITDA for various items, such as nonoperating or nonrecurring items. Inconsistent practices can make it difficult to assess company performance against competitors.
For example, one company might adjust its EBITDA for nonrecurring and extraordinary business charges, such as goodwill impairment, restructuring expenses and the cost of long-term incentive compensation. Another company in the same industry adds back none of those charges when calculating EBITDA. Comparing EBITDA between these competitors would be like comparing apples to oranges, unless you took the time to recalibrate those metrics using a consistent approach. Making reliable adjustments can be especially challenging for external stakeholders with limited access to a company’s financial data.
Incomplete Financial Picture
EBITDA isn’t a complete road map, even when it’s calculated consistently and used to evaluate a single company’s performance over time. For example, it’s commonly viewed as a shortcut to estimating operating cash flow. In reality, EBITDA and operating cash flow can differ significantly.
EBITDA is an accrual-based measure that strips out interest, income taxes, depreciation and amortization. Operating cash flow, on the other hand, reflects actual cash generated or used by operations during a period, as reported on the statement of cash flows under GAAP.
EBITDA excludes several key items that affect a company’s operating cash flow, including:
· Changes in working capital (such as accounts receivable, inventory and accounts payable),
· Cash interest and income taxes, and
· Noncash and timing-related items.
EBITDA also fails to capture a company’s full cash flow story. Although some EBITDA proponents argue that depreciation and amortization charges reasonably approximate capital expenditures, that’s not always true. And EBITDA may not reflect cash flows from other investing or financing activities, such as divestitures, principal repayments and dividend payments. Moreover, over-reliance on earnings-based metrics can cause internal and external stakeholders to miss other operational issues and risks, such as outdated technology, underutilized assets, excessive debt loads and unrecorded liabilities.
Bridging the Gap
Despite its shortcomings, EBITDA can be useful when evaluated alongside more traditional GAAP metrics. It may also be helpful to create a “bridge” that connects earnings to cash flow and provides a clearer picture of operational performance, liquidity and financial resilience. This schedule starts with EBITDA and systematically adjusts it to arrive at operating cash flow (or free cash flow).
For companies, lenders and investors alike, understanding what lies between EBITDA and cash flow is often where the most valuable insights are found. Contact your H&S team to explore the strengths and limitations of EBITDA and how linking it to cash flow can help keep your financial decisions on track.
