EBITDA vs. Free Cash Flow - A Study in Viability and Value Indicators

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Mar 2003

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On the evening of June 25, 2002, the financial networks were
reporting one story: WorldCom! Various networks and commentators were each
reporting that WorldCom's cash flow had been overstated by $3.3 billion.
That news was enough to make any auditor cringe; after all, they were talking
about cash, not off-balance sheet financing or special purpose entities. Cash
is, well, cash. The Statement of Cash Flows should tie to the balance sheet
through a simple reconciliation process.

As the networks
continued to report, it became clear that WorldCom's cash flow
wasn't overstated. Instead, the company had misclassified certain
expenses, which led to greater EBITDA. The network reporters—educated
members of the financial community—were incorrectly using the terms EBITDA
and cash flow interchangeably.

<h3>EBITDA Is Not Cash Flow</h3>

EBITDA
is defined as Earnings Before Interest Taxes Depreciation and Amortization. It
is a measure of operating results that has gained popularity with the investing
community over the years because it removes certain large non-cash
expenditures from the results reported on a company's Statement of
Operations (P&L) to arrive at a number that more closely resembles the
company's cash flow. It gained increased popularity as a measure in the
mid-80s as a result of the great number of corporate acquisitions at multiples
in excess of book value. The acquisitions created substantial amounts of
goodwill on corporate balance sheets. In accordance with the generally accepted
accounting principles (GAAP) that were in effect at the time, this goodwill was
amortized against future operating results. Many companies reported large
bottom-line losses as a result of the non-cash charges. EBITDA removed these
charges, creating a rosier picture for investors trying to gauge a company's
financial strength. Although it is conceptually a better indication of cash
flow than net earnings or operating income, EBITDA is not synonymous with cash
flow.

EBITDA as a measure
falls short of cash flow for many reasons. First, it makes no allowance for the
amount of capital expenditures made by a firm in a given period. Capital
expenditures, real cash outflows, are recorded on the balance sheet and
recognized as expenses in later periods. This is consistent with what in
accounting is referred to as the matching principal, where expenses are
reported in the periods in which the related revenue is generated or the asset
is consumed. For this reason, large capital expenditures are not recognized on
the P&L in the period in which they are made, and therefore not reflected
in that period's EBITDA. Furthermore, under GAAP, capital expenditures
are depreciated in subsequent periods and never reflected in EBITDA. Capital
expenditure requirements can put a great deal of stress on a firm's
capital structure and threaten its viability.

Second,
EBITDA also makes no provision for the effectiveness of a firm in managing its
working capital. EBITDA normally ignores a firm's ability to manage its
receivables and payables, and collect cash. As a result, EBITDA ignores the quality
of a firm's customer base and the non-interest bearing financing obtained
through vendor credit. Finally, non-cash earnings such as those resulting from
barter transactions can inflate EBITDA. Although these transactions can create
value, they have no impact on a firm's cash flow.

Third,
EBITDA does not account for quality of earnings. Many industries that service
long-term contracts book revenue based on a percentage of completion. Revenue
is recognized as costs that are incurred on a project. If 1/3 of estimated
total costs have been expensed, 1/3 of estimated total revenue is booked with
an unbilled receivable appearing on the company's balance sheet. Once the
project is complete or a billing milestone is reached, the unbilled receivable
is billed to the customer, and cash is collected. Depending on the duration of
the construction project, revenue and EBITDA may appear robust, while the
company struggles to meet its current obligations due to the working capital
crunch.

There
is a measure of operations currently being used that bears a closer resemblance
to a firm's cash flow than EBITDA, and that is Free Cash Flow (FCF). In
its simplest form, FCF is the net amount of (1) reported profit, adjusted for
depreciation, depletion and other non-cash accounting elements, less (2) new
investment in facilities, and plus or minus (3) changes in working capital.<a href="#3" name="3a">3</a>

FCF not only incorporates cash outflows associated with capital expenditures,
but also captures a firm's ability to effectively manage its working
capital.

FCF
as a measure is less impacted by management discretion and accounting treatment
of transactions than EBITDA. For example, the management team of
WorldCom's decision to treat various cash expenditures as capital
expenditures rather than operating expenses would have had no impact on the
calculation of World-Com's FCF.

For
these reasons, FCF is a better indicator of a firm's ability to generate
cash, its related viability and ultimate value than EBITDA.

<h3>A Study in Correlation</h3>

The
correlation between EBITDA and FCF varies depending on many factors including a
company's industry and life cycle. For example, start-up enterprises and
high-technology businesses tend to have large amounts of capital investment. In
these environments, FCF and EBITDA have a low correlation. When analyzing the
viability of these businesses, EBITDA is extremely misleading because it
ignores the large amounts of cash required to support the growth and
technological development of these businesses.

In
preparing this article, the authors analyzed the correlation between FCF and
EBITDA for 42 companies recently emerging from or currently under chapter 11
bankruptcy protection.<a href="#4" name="4a">4</a> The analysis compared the results of operations for the
last fiscal year immediately preceding each company's petition date as
measured by both FCF and EBITDA.

The
results of this study showed that while more than 33 percent of these companies
had positive EBITDA, they had negative FCF. In analyzing the pre-petition
viability of these companies, operations as measured by FCF would have been a
better measure than EBITDA. A positive EBITDA would not have been a true
picture of the cash demands on these businesses.

The
study also showed that the correlation between the two measures greatly varied
by industry. For example, the EBITDA and FCF margins for the telecom industry
were -0.8 percent and -31.9 percent respectively, whereas these same margins
for the manufacturing and retail industry were 1.6 percent and -1.6 percent,
respectively.

The
large variance in the telecom industry data can primarily be attributed to
larger capital expenditures pertaining to the build-out of networks and
development of technologies. On average, of the 13 telecom companies included
in the study, annual capital expenditures for the last fiscal year preceding
the chapter 11 filing was more than 42 percent of annual revenues, whereas it
was less than 4 percent for the 16 manufacturing and retail companies included
in the study.

In
addition, EBITDA, as compared to FCF, has been inflated due to the
vendor-financing deals, non-cash IRU transactions and other barter
transactions prevalent in the telecom industry. These transactions generated
EBITDA, but had less impact on FCF.

As
demonstrated in the accompanying chart, EBITDA consistently reported better
positive results or less negative results when measured against FCF.

<h3>An Integrated Approach</h3>

Although
FCF is often a better measure than EBITDA in analyzing the results of
operations for any business, there is an inherent danger in using any one
measure in assessing a firm's value and viability.

FCF
as a measure does reflect the pressure of capital investment, working-capital
efficiency and quality of a firm's earnings; however, it ignores other
threats to a firm's viability, including its ability to service the
interest and principal obligations of its existing capital structure. Although
FCF may reflect sufficient cash to fund existing operations and required
capital investment, if the amount of FCF is not sufficient to satisfy a
firm's existing obligations, the viability of the business may be in
question.

For these reasons, a single measure of operating performance is insufficient. A
simple, yet more integrated approach is necessary. A reasonable analyst does
not rely on any one single indicator, especially in given industries. When
assessing the value and viability of a company, it is important to use an
integrated approach that not only includes items from the P&L and Statement
of Cash Flows, but also includes an assessment of the strength of
company's balance sheet and ability to meet existing obligations.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Joe
Sciametta is a restructuring professional whose experience includes both debtor
and creditor representations. <a href="#1a">Return to article</a>

<a name="2">2</a> Jack
Kloster is a manager in Huron Consulting Group's Corporate Advisory
Services practice. Jack's restructuring experience includes debtor and
creditor representations for telecom, health care and manufacturing companies. <a href="#2a">Return to article</a>

<a name="3">3</a> Helfert,
Erich A. D.B.A., Techniques of Financial Analysis: A Modern Approach, Ninth Edition, Irwin. <a href="#3a">Return to article</a>

<a name="4">4</a> The
authors thank Angela Tsai for her assistance with the preparation of the
analysis. <a href="#4a">Return to article</a>

Journal Authors

Jack Kloster

Joseph Sciametta

Journal Date

Saturday, March 1, 2003 - 12:00

Bankruptcy Rule

2003