Free Cash Flow vs. EBITDA: An Overview
Free cash flow (FCF) and earnings before interest, tax, depreciation, and amortization (EBITDA) are two different ways of looking at the earnings a business generates.
There has been some discussion regarding which method to use in analyzing a company. EBITDA sometimes serves as a better measure for the purposes of comparing the performance of different companies. Free cash flow is unencumbered and may better represent a company’s real valuation.
Key Takeaways
- Both free cash flow (FCF) and earnings before interest, tax, depreciation, and amortization (EBITDA) are methods for examining the earnings a business generates.
- Each method has its pros and cons as a measure, but EBITDA may be more useful when comparing the performance of different companies.
- FCF, on the other hand, may provide a better way to analyze a company's performance on its own merits because it can provide insight into the level of earnings a firm has after meeting its interest, tax, and additional obligations.
Free Cash Flow
Free cash flow is considered to be "unencumbered."Analysts arrive at free cash flow by taking a firm’s earnings and adjusting them by adding back depreciation and amortization expenses. Then deductions are made for any changes in its working capital and capital expenditures. They consider this measure as representative of the level of unencumbered cash flow a firm has on hand.
When it comes to analyzing the performance of a company on its own merits, some analysts see free cash flow as a better metric than EBITDA. This is because it provides a better idea ofthe level of earnings that is really available to a firm after it covers its interest, taxes, and other commitments.
EBITDA
EBITDA, on the other hand, represents a company’s earnings before taking into account essential expenses such as interest payments, tax payments, depreciation, and certain capital expenses that are accounted for, or amortized, over a period of time. Also, EBITDA doesn't take into account capital expenditures, which are a source of cash outflow for a business. These are amounts that are really not available to the firm.
EBITDA may be a better way to compare the performance of different firms. Considering that capital expenditures are somewhat discretionary and could tie up a lot of capital, EBITDA provides a smoother way of comparing companies. And some industries, such as the cellular industry, require a lot of investment in infrastructure and have long payback periods. In these cases, too, EBITDA may provide a better basis for comparison by not adjusting for such expenses.
EBITDA provides a way of comparing the performance of a firm before a leveraged acquisition as well as afterward, when the firm might have taken on a lot of debt on which it needs to pay interest.
Key Differences
One example of a scenario in which EBITDA may prove a better tool than free cash flow is in the area of mergers and acquisitions, where firms often use debt financing, or leverage, to fund acquisitions. If you're trying to compare firms that have taken on a lot of debt (as they might have in this case) with those that have not, free cash flow may not prove the best method. In this case, EBITDA provides a better idea of a firm's capacity to pay interest on the debt it has taken on for acquisition through a leveraged buyout.
There is less scope for fudging free cash flow than there is to fudge EBITDA. For instance, the telecom company WorldCom got caught up in an accounting scandal when it inflated its EBITDA by not properly accounting for certain operating expenses. Instead of deducting those costs as everyday expenses, WorldCom accounted for them as capital expenditures so that they were not reflected in its EBITDA.
And when it comes to valuing a company—which involves discounting the cash flow it generates over a period of time by a weighted average cost of capital that accounts for the cost of debt funding as well as the cost of equity—a company’s free cash flow serves as a better measure.
What Is EBITDA?
EBITDA, an initialism for earning before interest, taxes, depreciation, and amortization, is a widely used metric of corporate profitability. It doesn't reflect the cost of capital investments like property, factories, and equipment. Compared with free cash flow, EBITDA can provide a better way of comparing the performance of different companies.
Which Is Better for Evaluating a Company's Performance, EBITDA or Free Cash Flow?
Some analysts believe free cash flow provides a better picture of a firm's performance. The reason? FCF offers a truer idea of a firm's earnings after it has covered its interest, taxes, and other commitments.
What Is the Formula for Calculating EBITDA?
Here is the formula for calculating EBITDA:
EBITDA = net income + interest + taxes + depreciation + amortization
A company's income statement, cash flow statement, and balance sheet all provide the information you need to calculate EBITDA.
FAQs
Furthermore, EBITDA does not include capital expenditures. In free cash flow, on the other hand, all depreciation and changes in working capital and capital expenditures are added to the revenues and interest and tax payments are deducted.
Is EBITDA the same as free cash flow? ›
Both free cash flow (FCF) and earnings before interest, tax, depreciation, and amortization (EBITDA) are methods for examining the earnings a business generates. Each method has its pros and cons as a measure, but EBITDA may be more useful when comparing the performance of different companies.
How do you convert EBITDA to FCF? ›
FCFF can also be calculated from EBIT or EBITDA: FCFF = EBIT(1 – Tax rate) + Dep – FCInv – WCInv. FCFF = EBITDA(1 – Tax rate) + Dep(Tax rate) – FCInv – WCInv.
Does positive EBITDA mean positive cash flow? ›
This means that a company with a strong EBITDA might not necessarily have strong cash flows. This is often the case in certain industries that require a substantial amount of capital expenditure (e.g., manufacturing), resulting in higher depreciation expenses and driving EBITDA and cash flow further apart.
What does EBITDA tell us? ›
EBITDA, or earnings before interest, taxes, depreciation, and amortization, is an alternate measure of profitability to net income. By including depreciation and amortization as well as taxes and debt payment costs, EBITDA attempts to represent the cash profit generated by the company's operations.
Is EBITDA higher than free cash flow? ›
Free cash flow can be higher or lower than EBITDA. In each case, it depends on the circ*mstances in the company, which expenditures were made. If the changes in working capital within a financial year are strongly positive because e.g. a large investment was made, the free cash flow can be less than EBITDA.
Why is EBITDA better than cash flow? ›
Essentially, EBITDA provides a clearer picture of a company's profitability from its core business operations by removing the effects of non-operating factors like investment sources, tax rates, and large non-cash expenses.
What does free cash flow tell you? ›
Free cash flow tells you how much cash a company has left over after paying its operating expenses and maintaining its capital expenditures—in short, how much money it has left after paying the costs to run its business.
What is the FCF EBITDA ratio? ›
Calculating the FCF conversion ratio comprises dividing free cash flow (FCF) by a measure of operating profitability, most often EBITDA (or EBIT). In theory, EBITDA functions as a rough proxy for a company's operating cash flow, albeit the metric receives much scrutiny among practitioners.
Why is EBITDA so important? ›
EBITDA indicates how well the company is managing its day-to-day operations, including its core expenses such as the cost of goods sold. As such, it is a very fair indicator of a business's current state and potential. In some cases, it is much fairer than either gross profit or net income.
PROS: 1: Comparability: EBITDA allows companies with different capital structures to be compared. 2: Simplicity: EBITDA provides a quick snapshot of a company's profit performance. 3: Proxy for Cash Generation: EBITDA is often used as a fast way to measure a company's ability to generate cash from its core operations.
What is EBITDA for dummies? ›
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a financial metric used to measure a company's operational performance and profitability by excluding non-operating expenses and accounting factors.
What is considered a good EBITDA? ›
A good EBITDA margin is relative because it depends on the company's industry, but generally an EBITDA margin of 10% or more is considered good. Naturally, a higher margin implies lower operating expenses relative to total revenue, while a low or below-average margin indicates problems with cash flow and profitability.
Why doesn t Buffett like EBITDA? ›
You might look profitable on your EBITDA--the money your business earns before paying interest, taxes, depreciation, and amortization. The problem, as Warren Buffett points out, is that you could be EBITDA positive and cashflow negative. And when a business runs out of cash, the music stops.
Why is EBITDA misleading? ›
EBITDA is an oft-used measure of the value of a business. But critics of this value often point out that it is a dangerous and misleading number because it is often confused with cash flow. However, this number can actually help investors create an apples-to-apples comparison, without leaving a bitter aftertaste.
Does EBITDA include owner salary? ›
EBITDA removes an owner's salary from the valuation because the buyer will need to spend this figure on a new manager or CEO. EBITDA is also used as a metric for public companies, but earnings, or simply net income, is more commonly used by publicly held companies.
Is EBITDA on the cash flow statement? ›
It is often claimed to be a proxy for cash flow, and that may be true for a mature business with little to no capital expenditures. EBITDA can be easily calculated off the income statement (unless depreciation and amortization are not shown as a line item, in which case it can be found on the cash flow statement).
Is EBITDA a perfect measure of cashflow? ›
It is a measure of a company's operating profit, or how much money it makes from its core business activities. EBITDA is often used as a proxy for cash flow, but it is not the same thing. EBITDA does not account for the cash inflows and outflows that affect a company's liquidity and solvency.
How do I calculate free cash flow? ›
The generic Free Cash Flow (FCF) Formula is equal to Cash from Operations minus Capital Expenditures. FCF represents the amount of cash generated by a business, after accounting for reinvestment in non-current capital assets by the company.
