Investors and financial professionals sometimes use the terms cash flow and EBITDA (earnings before interest, taxes, depreciation and amortization) interchangeably. In fact, they are not the same and provide different information when analyzing a company’s financial position.
A company’s cash flow is reported annually and quarterly in financial reports filed with the Securities and Exchange Commission (SEC). These reports show how much cash (if any) is being generated by a company’s operations and how it is being used.
A company’s cash flow statements have three sections: cash flow generated by or used by operations, cash flow generated by or used by investing activities, and cash flow generated by or used by financing activities. Cash flow from operations is net income plus noncash items and changes in working capital accounts. Investing activities include capital expenditures (or net changes in property and equipment), acquisitions and sales of businesses or other assets such as property, and other investing activities, and financing activities include cash raised from loans or by issuing debt or equity, principal payments on borrowings, share repurchases, and cash dividend payments.
When investment professionals talk about cash flow in relation to the cash flow statement that appears in a company’s SEC filings, they often mean cash that is generated by the company’s operations and, therefore, is available to reinvest in the business, make dividend payment, repurchase stock, repay debt, etc.
In addition, investment professionals sometimes refer to “free” cash flow. While there is more than one definition of free cash flow, the most common is cash generated by a company’s operations in a given year, less the year’s capital expenditures (which are assumed to be necessary to maintain and grow the company’s business) and dividend payments (which are a commitment made to shareholders that most companies’ boards of directors are loath to cut or eliminate except in dire circumstances). Therefore, free cash flow is a measure of how much excess cash a company’s operations are generating that could be used to take advantage of growth opportunities (such as expanding capacity or making acquisitions), to increase dividend payments to shareholders, to repay debt or for other purposes.
While cash flow is a relatively broad measure of cash generated by a company, EBITDA is a more limited measure of operating income (as reported on the profit and loss statement) before deducting interest, taxes, depreciation and amortization. If a company has debt, EBITDA is one measure of its interest coverage, or how much cash it generates relative to current interest payments.
In addition, EBITDA is sometimes used to estimate how much a company might be worth to an acquirer, since it is a measure of how much cash the company generates annually that can be used to pay interest not just on existing debt but on debt that might be added in the future. For example, if a company has EBITDA of $50 million and money can be borrowed at an interest rate of 6%, its EBITDA would support debt of approximately $833 million (6% of 833 million is $50 million).
This calculation is, of course, simplistic and would only be a starting point for a potential acquirer (or for a potential investor simply trying to value a company). Other considerations might be how stable is the company’s EBITDA (based on historical results), is its EBITDA growing, how much debt (if any) does the company already have on its balance sheet, and how much cash does it hold?
Both cash flow and EBITDA can be useful measures for investors, but, of the two, the broader measure of cash flow (and free cash) flow may be a better indicator of a company’s overall health.
