Don't confuse EBITDA as Cash Flow or Stability

by: Scott E. McGlon

From company owners to inexperienced deal analysts, many confuse EBITDA with cash flow. Clearly understanding the distinction between the two is critical whether you are a start-up, angel investor, or an established business looking to expand via acquisition or other means. 

When leveraged buy-outs (LBO) gained popular ground in the 80's and early 90's, EBITDA became the primary metric of choice to determine how much a company could potentially take on (the foundation of qualifying an LBO).  Since then, EBITDA has gained even more prominence since it is one of the baselines used to get to a starting-point valuation as a multiple of EBITDA. The multiple used usually is determined by industry and based on the current M&A supply & demand of the company being evaluated.  A key point is that the EBITDA metric is not uniformly defined under GAAP standards thus allowing many ways companies can calculate and, in some cases, manipulate EBITDA. This variance in how companies define EBITDA leads to inequalities and sometimes confusion regarding the true cash-generating abilities of a business. Depending on third-parties that look at EBITDA as one of their main metrics and the confidence level it creates, differences in EBITDA calculation usually lead to additional questions or more stringent due diligence. 

The key take-away's to understanding EBITDA is the fact that it does not take into account the following:

• the company's capital expenditures, 
• depreciation,
• taxes, 
• the company's current debt payments,
• working capital requirements, 
• or other fixed costs which the third party reviewing the EBITDA history should not ignore. 

If a company wants to grow, defend its market position, and remain viable & profitable, the monthly cash needed to finance the above obligations carries prominent importance.  There are three main costs that are not usually found in company's stated EBITDA which lead to overstated cash flows.  These are underestimating or accelerating depreciation, working capital adjustments to fuel growth, and week to week capital expenditures (capex).  

Depreciation - The over or underestimation of capital expenses for asset-heavy companies such as the trucking industry (over 30 years industry experience) is one of the oldest tricks in the book and can grossly skew available cash flow.  Adding back all depreciation for a company without leaving an allowance for capex will overestimate the available cash flow significantly. However, not adding back any depreciation can underestimate the cash flow.  This is especially true if a company uses accelerated depreciation to reduce its tax burden.  In most of these cases, the companies are profitable and carry little to no debt, Simply put, there have been a lot of cases over the years of companies manipulating depreciation schedules to inflate EBITDA. This is a true indication of a company that is not being true to their actual capex allowance needs.

Working Capital Adjustments - Most companies need to invest profits back into the company just to keep their growth objectives moving forward and to stay ahead of competition. EBITDA does not account for changes in working capital and the cash required to run the daily operating activities or the fluctuations associated with it. Ignoring working capital requirements assumes that a business gets paid before it sells its products or services - e-commerce companies for example. However, very few traditional companies operate this way. Most businesses provide a service and get paid in net 30 (industry average). Ideally, a business collects in advance for its services, pays off its due payables within terms or earlier, and uses its profits to reinvest into additional raw material inventory, products, or even staff. 

Capital Expenditures (capex) -  What assets or equipment is fundamentally required to operate?  This is a critical question for understanding a company's capex month-to-month requirements. Certain industries like transportation, heavy/industrial manufacturing, and oil & gas all require heavy, ongoing investment in equipment just to operate. Most EBITDA calculations do not take into account capex.  Line items within a chart of accounts balance sheet will show the significant investments in plant and equipment required to operate. EBITDA can get artificially inflated when companies capitalize operating expenses and allow them to be depreciated over time, thus decreasing operating expenses.  The closer you can get to fully understanding true capex, the more you can rely on EBITDA as a dependable metric.

In closing, the EBITDA metric has received a bad reputation in recent years (post Internet bubble) but this should only be taken with entities using it in improper ways.  Just as a steering wheel is great for navigating an automobile, the same method is ineffective in steering your horse!  How you define EBITDA might be different than a featured company does. Bottom line, it shouldn't be used as the main metric in evaluating corporate profitability. 

Like any other metric you use in evaluating a business, EBITDA is only a single indicator. Depending on the company's accounting methodology, EBITDA could be construed as vague, unclear, and/or a great metric to hide the true financial story. The people that make up the business, the processes they have to execute, the market share it has, and the products they sell are all key indicators that must be defined thoroughly when making a business decision on any company.

Scott E McGlon is the President of McGlon Properties, LLC and the author of many blog post on MP Blog.  He has been a serial entrepreneur, investor, and president of many successful start-ups since 1998.