Among business owners, a common misconception pervades: that EBITDA is the same as cash flow. While most investment bankers and M&A advisors are mindful of the difference, some business owners need a reminder. EBITDA gained popularity as the LBO industry arrived in the 1980s. Buyout firms used EBITDA to assess how much debt a company could bear, which was a key component of leveraged buyout strategy. 

EBITDA is now a standard metric for valuations. Yet this metric is not consistently defined in GAAP standards, and calculations vary between companies. This significant variation is a source of misunderstandings and disparities about a business’s true cash generating potential. 

EBITDA fails to take into account working capital requirements, capital expenditures, current debt payments, and other important fixed costs that buyers should not ignore. The cash necessary to finance these obligations is an important factor in growth and profitability. 

Here is a brief overview of the costs that are not included in calculations of EBITDA. 

Capital Expenditures
Industries such as telecom, aviation, shipping, and oil and gas demand massive upfront investments in technology and equipment. EBITDA does not take into account capex, which is a balance sheet item that represents these types of investments. By ignoring how capital expenses affected their actual cash flow, and instead assuming that their EBITDA was an accurate representation, WorldCom miscalculated their actual earning potential by $3.8 billion. Failure to accurately differentiate cash flow and EBITDA ultimately played a key role in the giant’s ultimate bankruptcy. 

Depreciation 
Over and underestimation of capital expenses for asset-heavy industries is a common problem. Adding back depreciation for these companies while failing to leave a capex allowance can massively inflate cash flow. Likewise, not adding back any depreciation can underestimate cash flow. In either scenario, companies end up with an inaccurate estimate of value that can prove catastrophic down the road. 

Adjustments to Working Capital 
It is generally understood by business owners that they must invest some portion of revenue in the company to continue growing. When there is a change to working capital, it is possible for EBITDA to overestimate the actual cash flow of a business. Ignoring working capital requirements makes the erroneous assumption that businesses can be paid before making sales. Almost no companies operate this way. Most provide a service or product and are paid in arrears. Ideally, businesses collect for their services upfront so they can remain as liquid as possible. The relationship between cash sources and uses is a measure of the company’s ability to take on new projects, including higher debt payments.

EBITDA is a useful figure for comparing two companies, especially if they are in the same industry or rely on similar business models. But owners should be suspicious of unclear accounting methodologies that rely too heavily on EBITDA. EBITDA is just one tool—not the only tool. 

So when you’re preparing to sell, work with an investment banking expert who can document and explain their valuation estimation. Evidence-based approaches sell businesses. Anything else is just wishful thinking. 

About Madison Street Capital
Madison Street Capital is an international investment banking firm committed to integrity, excellence, leadership and service in delivering corporate financial advisory services to publicly and privately held businesses.

Over the years we have helped clients in hundreds of industry verticals reach their goal in a timely manner. Our experience and understanding in areas of corporate finance and corporate governance is the reason we are a leading provider of financial advisory services, M&A, and valuations. With offices in North America, Asia and Africa, we have adopted a global view that gives equal emphasis to local business relationships and networks.