EBITDA vs. Operating Cash Flow vs. Free Cash Flow
Moderator note (Andy): this is a post from 2010 but squawkbox suggested its relevancy remains and can be very useful for those going through FT & SA interviews. "Don't beat it to hell because it's missing some small details, but it's good for what someone will need in the "hotseat" during the technical part of the interview".
Noticed EBITDA has been a common source of confusion. I hope this helps anyone with SA or FT interviews coming up. I left out some of the minutiae to keep it as relevant as possible.
EBITDA = Earnings Before Interest Taxes Depreciation and Amortization
EBITDA = Operating Income + Depreciation + Amortization
= EBIT + Depreciation + Amortization
= Net Income + Income Tax Expense + Interest Expense + Depreciation + Amortization
***For advanced readers: it will also exclude stock based compensation in most instances since this is a non-cash charge**
Why do we prefer EBITDA over Net Income to gauge the strength/weakness of the firm?
1) In general, it is a much stronger indicator of ongoing, operational strength for the firm.
2) Taxes are considered "non-operational" in a sense because they can be affected by a variety of accounting and tax conventions. These have no bearing on the ongoing, operational strength of the firm. Companies with significant losses in the past will have "artificially" low taxes rates once they become profitable due to something called NOLs (e.g. Biotechs, Technology co's).
3) Interest expense is a function of leverage, not operations. Companies in any given industry will have varying degrees of interest expense based on the debt load they incur.
4) Depreciation expense is an accounting convention based on the PP+E of the firm. It has no bearing on the ongoing operational strength of the firm. Firms with high capital requirements (manufacturing, autos, retail, aircraft builders, airlines, transports) will have very high depreciation expense due to the nature of the assets they hold. We need to take depreciation "out" in order to see how the firm's operations actually performed in a given year
5) Amortization expense is another accounting convention dealing with the amortization of intangibles. Because it is an accounting convention, we want to take it "out" also. Companies with significant intangible assets on their balance sheets will have material amortization expenses reducing operational income. These usually result from acquisitions.
Cash Flow from Operations (CFO/OCF)
CF from Ops
= Net Income + Depreciation + Amortization
- Chg in Non Cash Current Assets(Inventory, A/R) + Chg in Non Debt Current Liabilities(A/P, Deferred Revs) + Non-Cash Items
= Net Income + Depreciation + Amortization - Chg Non Cash Working Capital + Non-Cash Charges
Why do we need Cash Flow from Operations when we already have EBITDA ?
The key OPERATIONAL distinction between EBITDA and CFO/OCF is the Change in Net Working Capital. CFO/OCF are also burdened by taxes and interest expense.
Both will usually exclude the non-cash, one-time items.
There are many operational factors which come into account in the Change in Net Working Capital:
a) Deferred Revenue --> there are certain products and services a company can sell which will not show up in the traditional revenue account on the income stmt. A great example is the iPhone. Apple can only recognize (3/24) of the revenue of each iPhone they sell in a given quarter. As a result, EBITDA and Net Income are severely understated if we want to know Apple's operational performance for a given time period. However, the remainder of the revenue shows up in the Operating Section of the Cash Flow Statement. Compare Apple's Net Income to their Cash Flow from Operations to see the effect.
b) Operational Efficiency --> one example is inventory management. If a company needs more inventory, then that will require spending cash that could be put to other uses. This means that the current asset, inventory, goes up and "uses" cash. Another example is credit policy. What would be preferable, a company which only takes cash or one that allows you to push off payment for a year @ 0% interest. If a company records $100 of revenue but does not collect cash, then accounts receivable (current asset) will rise and "use" cash.
Free Cash Flow (FCF )
Unlevered FCF = Free Cash flow to Firm (FCFF) = EBIT(1-T) + D&A - Change in NonCash WC - CAPEX
The FCFF represents the cash flows available to ALL investors after mandatory cash outflows for business needs have been taken out (including taxes).
The reason we need FCF instead of EBITDA and OCF is the CAPEX adjustment. Any capital intensive company will be spending money on a regular basis to buy/modify/upgrade/replace their fixed assets (stores, machines, equipment, airplanes). Capex can represent a significant reduction in cash flow for many of these companies. Look at the Cash Flow Statement for any of the airlines to see the effect. Capex is an ongoing, operational cash outflow that must be considered.