In the worlds of M&A and valuation, companies’ values are often quoted based on multiples of EBITDA.
EBITDA, which is shorthand for earnings before interest, taxes, depreciation, and amortization, is a commonly used proxy for an entity’s ability to generate cash flow. Moreover, EBITDA serves as a useful basis for comparison between like companies which may have different capital structures, operate in different regulatory environments, or employ differing depreciation policies or asset utilization/ownership strategies.
However, its usefulness is limited to the financial sophistication of its user. In fact, in very few instances is EBITDA a reliable indicator of cash flow. This article briefly discusses differences between EBITDA and cash flow and highlights a few real world examples of differences in these metrics.
For purposes of this article, we will assume that an entity’s cash flow is synonymous with the sum of its cash flow from operations and cash flow from investing activities.
Some of the more significant differences between EBITDA and cash flow include:
Perhaps no difference is as significant as the treatment of working capital. In the calculation of EBITDA, working capital is ignored; however, in the calculation of cash flow, changes in working capital have a dollar-for-dollar impact on cash flow. Knowing how working capital affects a company’s valuation and each of these metrics is particularly important when evaluating companies that exhibit fast growth, varying balance sheets, or insufficient working capital.
Impact: All else equal, for a company that has increases in working capital, EBITDA will exceed cash flow.
Depending on the industry, the treatment of capital expenditures (“CapEx”) can also result in significant differences. In the calculation of EBITDA, no consideration is given to CapEx as EBITDA considers earnings before depreciation with no accommodation for CapEx. However, the calculation of cash flow considers the impact of CapEx after adjustment for the non-cash nature of depreciation.
Impact: All else equal, for a company with CapEx, EBITDA will exceed cash flow.
Capital leases are recorded as fixed assets with corresponding depreciation. Similar to the above discussion of CapEx, the capitalization of capital leases will result in differences between EBITDA and cash flow. Note that proposed changes in accounting guidance will likely require the capitalization of leases which were formerly classified as operating leases, thereby increasing the number of instances in which EBITDA and cash flow differ.
Impact: All else equal, for a company with capital leases, EBITDA will exceed cash flow.
Reserves and Allowances
Some of the more common reserve and allowance accounts include those for sales returns, product warranties, bad debts and excess or obsolete inventory. Any time a reserve is increased to account for a loss event, income is reduced. EBITDA is generally calculated to include the income statement effects of reserves, while cash flow is not directly affected by increases in reserves since these entries are non-cash in nature.
Impact: All else equal, for a company that incurs expenses by increasing its reserves and allowances, cash flow will exceed EBITDA.
Federal, state/franchise and local income taxes are excluded from the calculation of EBITDA. The most practical reason for this treatment is that, theoretically, the business’ operations are separate from the taxing environment in which the business resides. However, income taxes represent real obligations and affect a business’ cash flow.
Impact: All else equal, the lack of consideration of income taxes will cause a company’s EBITDA to exceed its cash flow.
The Calculation Base
EBITDA is typically calculated from a base of operating income, whereas cash flow (as we have defined above) is calculated beginning with net income (which is a component of cash flow from operating activities). This may seem like a negligible difference, especially when certain one-time non-cash gains and losses are adjusted out of net income in the calculation of cash flow (thereby increasing the comparability of operating income and adjusted net income). However, other income/expense items such as scrap income and miscellaneous expenses can result in a material difference between operating income (EBITDA) and adjusted net income (cash flow).
Impact: All else equal, to the extent a company’s other income/expense items are net negative and not related to non-cash gains or losses, EBITDA will exceed cash flow.
Non-Cash Income and Expense Items
As indicated above, EBITDA may include the effects of non-cash income and expense items, whereas cash flow removes the effects of such items. In addition to the non-cash items already mentioned – depreciation, amortization, reserves and allowances, and non-cash gains and losses – such non-cash income and expenses may also include stock-based compensation, asset write-downs and restructuring costs, goodwill impairments, and foreign currency translation and remeasurement adjustments.
Impact: All else equal, to the extent EBITDA is decreased by net negative non-cash items, cash flow will exceed EBITDA.
Clearly, there are a number of factors that can contribute to significant differences between EBITDA and cash flow. Generally, these factors result in EBITDA appearing greater than cash flow; however, this is not always the case. Still, regardless of the differences, it is clear that EBITDA should not be confused with cash flow.
To further this topic and provide a few real world examples of differences in these metrics, we have included below selected financial information from three U.S. companies whose common stock represents some of the most actively traded common stock in the U.S. financial markets.
Facebook reported 2013 EBITDA of $3,932 million, while it reported cash flow (excluding investments in marketable and equity securities) of $2,481 million. This represents a difference of $1,451 million.
Some of the primary differences include $1,730 million in net CapEx and cash acquisitions (which decrease cash flow), $1,254 in income tax expenses (which decrease cash flow), $906 million in stock-based compensation (which increase cash flow), and $639 million in decreases to working capital and like accounts (which increase cash flow).
Facebook’s reported 2013 revenue of $7,872 million. Accordingly, EBITDA as a percentage of revenue was 50% while cash flow as a percentage of revenue was nearly 32%.
General Motors Company
GM reported 2013 EBITDA of $12,105 million, while it reported cash flow (excluding investments in marketable and equity securities) of $(1,868) million. This represents a difference of $13,973 million.
Some of the primary differences include $11,329 million in net CapEx and cash acquisitions (which decrease cash flow) and $3,283 million in increases in purchases and funding of finance receivables (which decrease cash flow).
GM’s reported 2013 revenue of $155,427 million. Accordingly, EBITDA as a percentage of revenue was 8% while cash flow as a percentage of revenue was -1%.
Verizon Communications Inc.
Verizon reported 2013 EBITDA of $48,574 million, while it reported cash flow (excluding investments in marketable and equity securities) of $23,922 million. This represents a difference of $24,652 million.
Some of the primary differences include $17,098 million in net CapEx and cash acquisitions (which decrease cash flow) and $5,730 in income tax expenses (which decrease cash flow).
Verizon’s reported 2013 revenue of $120,550 million. Accordingly, EBITDA as a percentage of revenue was 40% while cash flow as a percentage of revenue was 20%.
We hope this article gives our readers a better grasp of the differences between EBITDA and cash flow. If you are interested in learning more about this topic, please contact RubinBrown.
RubinBrown has a dedicated team of M&A professionals that can assist you at any point in your business' lifecycle, whether you are considering making an acquisition, divesting a business line or product, or readying your business for sale. RubinBrown has the experience to help your organization from the initial thought of buying or selling to the critical post-closing and integration activities that must occur. Our comprehensive approach maximizes the value of the transaction for our clients.
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