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.
FAQs
Furthermore, EBITDA does not include capital expenditures. In free cash flow, on the other hand, all depreciation and changes in working capital and capital expenditures are added to the revenues and interest and tax payments are deducted.
Is EBITDA the same as free cash flow? ›
FCF, unlike EBITDA, directly focuses on the actual cash generated by a company's operations. It considers not only operating profitability, but also capital expenditures and changes in working capital, which are essential for understanding a company's cash-generating ability.
How do you walk from EBITDA to free cash flow? ›
You can calculate FCFE from EBITDA by subtracting interest, taxes, change in net working capital, and capital expenditures – and then add net borrowing. Free Cash Flow to Equity (FCFE) is the amount of cash generated by a company that can be potentially distributed to the company's shareholders.
What is the FCF EBITDA ratio? ›
Calculating the FCF conversion ratio comprises dividing free cash flow (FCF) by a measure of operating profitability, most often EBITDA (or EBIT). In theory, EBITDA functions as a rough proxy for a company's operating cash flow, albeit the metric receives much scrutiny among practitioners.
What's the difference between free cash flow and earnings? ›
Unlike earnings or net income, free cash flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital from the balance sheet.
What is good free cash flow? ›
To have a healthy free cash flow, you want to have enough free cash on hand to be able to pay all of your company's bills and costs for a month, and the more you surpass that number, the better. Some investors and analysts believe that a good free cash flow for a SaaS company is anywhere from about 20% to 25%.
What do you mean by free cash flow? ›
What is free cash flow? Free cash flow, or FCF, is the money that is left over after a business pays its operating expenses (OpEx), such as mortgage or rent, payroll, property taxes and inventory costs — and capital expenditures (CapEx).
How to get from EBITDA to levered free cash flow? ›
The LFCF formula is as follows:
- Levered free cash flow = earned income before interest, taxes, depreciation and amortization - change in net working capital - capital expenditures - mandatory debt payments. ...
- LFCF = EBITDA - change in net working capital - CAPEX - mandatory debt payments. ...
- Year 2.
- EBITDA. ...
- CAPEX. ...
- Working capital.
This model is used to find the value of the equity claim of a company and is only appropriate to use if capital expenditure is not significantly greater than depreciation and if the beta of the company's stock is close to 1 or below 1.
What does EBITDA stand for? ›
Share. EBITDA definition. EBITDA, which stands for earnings before interest, taxes, depreciation and amortization, helps evaluate a business's core profitability. EBITDA is short for earnings before interest, taxes, depreciation and amortization.
EBITDA is a company's net income but excludes the impact of interest income or expense related to debt instruments, depreciation and amortization, and stated and federal income taxes.
What is a healthy FCF yield? ›
Free Cash Flow Yield determines if the stock price provides good value for the amount of free cash flow being generated. In general, especially when researching dividend stocks, yields above 4% would be acceptable for further research. Yields above 7% would be considered of high rank.
What are the pros and cons of EBITDA? ›
It is a measure of profitability. The benefit of EBITDA is that it focuses on a company's core performance rather than the effects of non-core financial expenses. The main drawback of EBITDA is that financial expenses can make a great difference to a company's financial health, thus creating a misleading impression.
What is better than EBITDA? ›
Benefits of net income
By taking into account all liabilities, net income indicates a company's total profit, not just its operating profit. It also gives a better sense of the company's liquidity, or cash on hand, compared with EBITDA, which doesn't account for cash that must cover interest, tax, and other costs.
Why is EBITDA more important than net income? ›
EBITDA is often used when comparing the performance of two different companies of various sizes. Since it casts aside costs such as taxes, interest, amortization, and depreciation, it can yield a clearer picture of the money-generating performance of the two businesses compared to net income.
Is EBITDA the same as cash flow from operations? ›
Unlike EBITDA, cash from operations includes changes in net working capital items like accounts receivable, accounts payable, and inventory. Operating cash flow does not include capital expenditures (the investment required to maintain capital assets).
How to calculate EBITDA from cash flow? ›
To calculate EBITDA, start with Operating Income or EBIT on the Income Statement and then add the Depreciation & Amortization (D&A) from the Cash Flow Statement. You add back D&A because it represents the allocation of spending on long-term assets (factories, buildings, IP, etc.) from previous periods.
What is a synonym for EBITDA? ›
Synonyms for Ebitda
n. core earnings. core income. earnings before interest taxes depreciation and amortization.
What is the difference between EBITDA and EBIT? ›
The fundamental difference between EBIT vs. EBITDA is that EBITDA adds back in depreciation and amortization, whereas EBIT does not. This translates to EBIT considering a company's approximate amount of income generated and EBITDA providing a snapshot of a company's overall cash flow.
What is the difference between EBITDA and FFO? ›
EBITDA → By ignoring working capital, FFO shares some similarities with EBITDA, but the metric is not exactly EBITDA, either. The notable difference is that EBITDA attempts to capture profitability from operations, while FFO is a levered metric (post-interest) and captures the effect of taxes and preferred dividends.
