EBITDA does NOT equal Cashflow

Anyone with a modicum of accounting knowledge knows that EBITDA is one of the measures of company profitability.

EBITDA is an acronym for Earnings before interest, tax, depreciation and amortization.

It is used quite commonly to compare the performance of “different” companies as it ignores the way in which the company is financed, taxation and the impact of depreciation.

And similarly, most informed businessmen know that profits do not equal cashflow.

And in the same vein, that long term of growth and indeed company survival depends on its ability to generate cashflows.

And yet amazingly, EBITDA is used in a cavalier way as a proxy for cashflow!

Whilst there is no debate about the importance of EBITDA, it is not uncommon in the world of private equity and leveraged buyouts for transactions to be based on an EBITDA multiple.

Even major banks regard the ratio of EBITDA to total debt as most important.

In truth, EBITDA does not equal “free cashflow” – to say nothing about that rather important level of cash from a shareholder perspective i.e. “cash available for dividends” – more commonly describe as “net cashflow”.

In order to convert EBITDA to “free cashflow”, it is necessary to deduct tax, based on PBIT (profits before interest and tax), adjust for movements in working capital, and capital expenditure.

So, unless a company has no tax liability, and no working capital and no capex – which of course could be a (remote) possibility, EBITDA does NOT equal cash flow.

A Real-Life Example

A good real-life example of the fundamental financial principle encompassed in this article is the recent debacle surrounding Steinhoff.

While it may be possible to fudge EBITDA, given its composition, it is infinitely more difficult to fudge the real cash flow position.

In my article “Zero Investment in Steinhoff” I recounted the reason why our highly respected and successful asset manager did not expose his clients to Steinhoff.

He cited 3 reasons, the last of which I related with strongly - “a persistent lack of free cash flow when analyzing the financial statements”

The Impact of this Misconception in Business Today

The consequence of this misunderstanding has different effects in different circumstances.

In the early 2000’s a large - seemingly successful - furniture retailer was saved from insolvency by the intervention of one of SA’s leading banks – whilst it negotiated its own exit by passing the company on to one of the company’s major competitors.

In the last year of its existence, the company reported a post- tax profit of R550 million, and caused its own demise by classical overtrading, which in turn made huge demands on its cash resources by way of additional working capital.

Clearly its working capital cycle was completely out of balance.

Clearly management did not understand the relationship between profits and cash.

In a different scenario, we were once tasked with the acquisition of number of companies by our client. The industry was competitive and overpopulated and our client decided on a strategy of “growth by acquisition”. In the original briefing by the CEO, we were informed that the target companies were not aware of the strategy and we were to act on behalf of an undisclosed buyer. Clearly our client did not have access to the financial performance of the target companies, and when asked “how are we going to value the proposed acquisitions”, the response was that we would use an EBITDA multiple of between 7 and 8.

We were informed that this approach had been very successful elsewhere in the world.

We asked what ROI was expected using this approach – and were met with a blank response.

Just another example of confusing EBITDA with cash flow.

Will a Financial Model Prevent this Error?

Bearing in mind the fundamental principles of best practice financial modelling methodology, and the composition of the financial statements, there should be no confusion whatsoever between EBITDA and cash flow.

The layout of the income statement and cash flow statement clearly defines these two related, but quite different values.

Furthermore, the process of linking the closing balance on the cash flow statement into the balance sheet as the accounting validation of the model reinforces the difference between the two measures.

Of course, it is not uncommon to commence the cash flow statement with EBITDA, but thereafter adjustments must be made for interest, funding, working capital, tax and capex.

What Happens When your Financial Model is Right?

When your financial model is right - i.e. based on realistic, well researched, pragmatic input assumptions and constructed in accordance with international best practice methodology, then management has a remarkably powerful tool to assist it in making informed decisions.

And in the volatile, uncertain, complex and ambiguous world in which businesses compete, a tool which can be extremely useful in dealing with the rate of change confronting business executives today.

In order for a model to have real value, in addition to the modelling conventions and methodology, it is paramount that the business case is thoroughly researched and understood.

This is the very first requirement of getting your model right!

And the second is to avoid confusing EBITDA with cash flow!

I am often asked about my passion for modelling - and my response is always the same - I have been privileged to be Chairman or CEO of a number of companies, private and public - and my passion stems not from an academic perspective, but from having had effective models to assist me in the real world.