EBITDA

IS
NOT
CASH
FLOW

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Earnings before Interest, Taxes,
Depreciation and Amortization
is calculated just as the name
implies:

+ Net profit before tax

+ Interest expense
+ Depreciation expense
+ Amortization expense

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 3 Benefits of EBITDA:

1. It is easy to calculate, and has

become universally used as the
language of cash flow.

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 3 Benefits of EBITDA:

2. It allows financial performance

comparisons across businesses.

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 3 Benefits of EBITDA:

3. It levels the analysis playing field

by removing the impact of the
company’s capital structure
(interest payments), operating
leverage (depreciation &
amortization), and related tax
implications (tax).

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 10 Flaws of EBITDA:

1. It implies that all net income

translates into cash the same
way, allowing companies to use
non-cash items to artificially
increase it.

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 10 Flaws of EBITDA:

2. It does not consider the amount

of required reinvestment,
especially for companies with
short-lived assets.

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 10 Flaws of EBITDA:

3. It does not account for working

capital changes caused by sales
growth or declining efficiency.

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 10 Flaws of EBITDA:

4. It implies that loan repayment

will be prioritized as part of cash
flow uses.

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 10 Flaws of EBITDA:

5. It doesn’t say anything about

the quality of earnings.

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 10 Flaws of EBITDA:

6. It is an inadequate stand-alone
measure for comparing
acquisition multiples.

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 10 Flaws of EBITDA:

7. It can be severely misleading

used as a single measure of cash
flow without consideration of other
factors.

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 10 Flaws of EBITDA:

8. It can be easily manipulated

through aggressive accounting
policies (revenue and expense
recognition, asset write-downs and
concomitant adjustments to
depreciation schedules, excessive
adjustments)

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 10 Flaws of EBITDA:

9. It is a poor measure of
profitability

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 10 Flaws of EBITDA:

10. It is not a GAAP metric so it’s not

formally defined and thus every
company defines and calculates it
however they like.

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 How to Use EBITDA - Externally

EBITDA is often the numerator for the

Debt Service Coverage ratio, which
divides EBITDA by the sum of the
interest expense and the current
portion of long-term debt
(EBITDA/Principal + Interest)

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 How to Use EBITDA - Externally

Tracking coverage ratios is

important to manage a company's
external financing relationships.
Whenever CAPEX or Distributions
become material, banks will
typically change the DSC covenant
to control for these cash outflows.

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 How to Use EBITDA - Externally

The coverage ratio typically used to

replace Debt Service Coverage Ratio
(DSC) to account for the known
flaws of EBITDA is Fixed Charge
Coverage Ratio (FCCR)

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 How to Use EBITDA - Externally

Fixed Charge Coverage Ratio (FCCR)

FCCR = (EBITDA - Cash Taxes -

Distributions - CAPEX) / (Principal +
Interest)

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 How to Use EBITDA - Externally

Note that working capital isn’t

usually adjusted for in the FCCR
formula due to the fact lenders
typically finance the working capital
assets, so they don't need to control
for these cash outflows reducing
EBITDA.

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 How to Use EBITDA - Externally

The strength of the underlying cash

flow can be better understood by
breaking down EBITDA into EBIT and
depreciation and amortization. The
greater the depreciation and
amortization in EBITDA, the weaker
the underlying cash flow.

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When to Use EBITDA - Internally

Appropriate as a cash flow tracking

metric when a company has:
-few non-operating income sources
-very little sales growth
-constant cash flow drivers
-capital expenditures approx. equal
to annual depreciation expense

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