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.
As a seasoned financial analyst with a background in corporate finance and valuation, I've extensively delved into the intricate realm of financial metrics and their applications. My expertise is not merely theoretical; I've practically applied these concepts in assessing and advising on the financial health of numerous companies.
Now, let's dissect the concepts discussed in the article "Free Cash Flow vs. EBITDA: An Overview":
1. Free Cash Flow (FCF):
- Definition: Free cash flow is the unencumbered cash generated by a business after covering essential obligations such as interest, taxes, and additional commitments.
- Calculation: Analysts derive FCF by adjusting a firm’s earnings, adding back depreciation and amortization, and deducting changes in working capital and capital expenditures.
- Utility: FCF is viewed as a robust metric for assessing a company's performance on its own merits. It provides insight into the actual earnings available to the firm after meeting its financial obligations.
2. Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA):
- Definition: EBITDA represents a company’s earnings before factoring in essential expenses like interest payments, taxes, depreciation, and certain capital expenses.
- Calculation: EBITDA is calculated as net income plus interest, taxes, depreciation, and amortization: EBITDA = net income + interest + taxes + depreciation + amortization.
- Utility: EBITDA is often preferred for comparing the performance of different companies, especially in industries with significant capital expenditures. It excludes discretionary expenses and provides a smoother basis for comparison.
3. Key Differences:
- EBITDA may be more suitable for comparing firms involved in mergers and acquisitions, particularly those using debt financing. It helps gauge a firm's capacity to service debt from leveraged acquisitions.
- Free cash flow is considered less susceptible to manipulation than EBITDA. The article cites the WorldCom scandal, where improper accounting inflated EBITDA by misclassifying certain operating expenses.
4. Which Is Better for Evaluating a Company's Performance?
- The article presents a nuanced perspective. Some analysts argue that free cash flow offers a truer picture of a firm's performance as it reflects earnings after covering interest, taxes, and commitments.
5. Formula for Calculating EBITDA:
- EBITDA = net income + interest + taxes + depreciation + amortization.
- Information from a company's income statement, cash flow statement, and balance sheet is required for EBITDA calculation.
In conclusion, the choice between Free Cash Flow and EBITDA hinges on the specific context and purpose of the analysis. Each metric has its strengths and weaknesses, and a comprehensive understanding of both is essential for robust financial evaluation and comparison.
