EBITDA - The Myth & Truth

In this post we will understand the pitfalls of using EBITDA as a barometer of a company's business strength and will also understand how Cash Flow from Operations and FCF can help to have better insights in a company's business strength

Analysts often use EBIDTA to evaluate company financials. EBIDTA is essentially earnings before interest, tax, depreciation and amortization and is commonly referred to as operating profit. The operating profit is a measure of how well a company is able to manage expenses in running the day-to-day operations. But EBIDTA may not give the complete picture of a company's business strength. 

More often than not companies try to dress up financial statements using EBIDTA and such companies are more likely to do fraudulent transactions. Since EBIDTA excludes a number of non-cash charges, it does not give a true picture of a company's financial standing. One of the non-cash charge excluded is depreciation. In reality, depreciation entails outflow but only after a longer period of time. To understand this let us try to analyze the nature of depreciation expense in more detail. 

Plant and machinery is an important lifeline asset for a brick and mortar company. As per generally accepted accounting principles (GAAP), a company is required to amortize the machine cost over its useful life which in accounting language is known as depreciation. Therefore, depreciation has the impact of reducing reported profits each year although it does not result in immediate cash outflows. In that sense it is non-cash in nature. So depreciation allowance contributes to cash in the short term. 

In other words, depreciation can be looked upon as a yearly contribution towards a sinking fund to finance the replacement of the worn out plant & equipment. Amortization of goodwill, on the other hand, represents a yearly charge for an expenditure that happened in the past and for which the cash flows have already taken place. 

Therefore a more correct measure to evaluate business performance is to look at cash flows from operations obtained by adding back depreciation and amortization to after-tax earnings. 

Cash Flow from operations = Profit after Tax + Depreciation + Amortization 

This indicator factors in huge interest outflows in case of debt-ridden companies. But a more accurate indicator of a company's ability to profitably run business is the 'Free Cash Flow'. Free Cash Flows measure a company's ability to meet short term outflows to fund working capital as well as long term outflows for capital expenditure. Free Cash Flow is obtained by adjusting cash flow from operations for working capital changes (operating cash flows) and deducting capital expenditure. 

Free Cash Flow = Operating Cash Flow - Capital Expenditure 

A positive and high free cash flow indicates that the business is generating a lot of cash, a vital factor to drive its future growth. A negative free cash flow, on the other hand, shows that the business is burning cash which can be detrimental for a company's survival in the long run. 

Many companies with their asset-light franchise based business models are big cash generators.