Commonly Confused Metrics: EBITDA vs Free Cash Flow

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To perform industry comparisons, each metric should be calculated under the same standards. A Simple Model exists to make the skill set required to build financial models more accessible. We hope this guide has been helpful in understanding the differences between EBITDA vs Cash from Operations vs FCF vs FCFF. The fact is, the term Unlevered Free Cash Flow (or Free Cash Flow to the Firm) is a mouth full, so finance professionals often shorten it to just Cash Flow.

However, we should not rely solely on accrual-based accounting, either, and must always have a handle on cash flows. Since accrual accounting depends on management’s judgment and estimates, the income statement is very sensitive to earnings manipulation and shenanigans. Two identical companies can have very different income statements if the two companies make different (often arbitrary) deprecation assumptions, revenue recognition and other assumptions. Imagine if you only looked at cash from operations for Boeing after it secured a major contract with an airliner.

This can provide insights into a company’s growth trajectory and operational efficiency. A company might have high EBITDA but low FCF due to significant capital expenditures or working capital needs. In these examples, we can see how different business models and stages of growth can affect the relationship between EBITDA and FCF. The tech startup has a higher proportion of FCF to EBITDA due to lower capital expenditures, while the established manufacturer’s FCF is a smaller percentage of its EBITDA due to higher capital expenditures. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s a measure of a company’s overall financial performance and is used as an alternative to net income in some circumstances.

To calculate EBITDA, one starts with the net income, which is the profit after all expenses have been deducted. From this figure, interest, taxes, depreciation, and amortization are added back. Understanding the financial health of a company is crucial for investors, analysts, and business leaders. Two key metrics often used in this evaluation are EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and Free Cash Flow (FCF). While EBITDA provides insight into operational profitability, FCF offers a clearer picture of the cash available after capital expenditures. EBITDA to FCF conversion is a general formula that may not be suitable or relevant for some companies or industries.

By comparing these metrics side by side, businesses and investors can gain a holistic view of an organization’s financial health. This comparison is particularly valuable when making decisions related to investments, valuations, and growth strategies, as each metric sheds light on unique financial dynamics that the other may overlook. Free cash flow conversion is a simple yet effective formula for understanding a company’s financial condition. While it can stand alone, combining it with other financial ratios enhances accuracy. There is less scope for fudging free cash flow than there is to fudge EBITDA.

From EBITDA to Free Cash Flow: A Financial Analysis Guide

• When finance professionals refer to EBITDA as a proxy for “cash flow,” they typically mean cash flow from operations, or operating cash flow.
• Working capital, the difference between a company’s current assets and current liabilities, plays a significant role in the transition from EBITDA to Free Cash Flow (FCF).
• By converting EBITDA to FCF, businesses can gain a deeper understanding of their financial performance and make better-informed decisions.
• This can be particularly useful when comparing companies in the same industry, as it eliminates some of the variations caused by differences in capital structure and accounting practices.
• These expenditures, while reducing short-term free cash flow, can lead to increased revenues and profitability in the long run.

It does not account for the effects of interest, taxes, debt, and equity financing. EBITDA to FCF conversion is an estimate of the cash flow that a company generates from its operations, but it does not reflect the cash flow that is available to its shareholders or creditors. To calculate the free cash flow to equity (FCFE) or free cash flow to firm (FCFF), we need to account for the effects of interest, taxes, debt, and equity financing on the cash flow statement.

FCFE = EBITDA – Interest – Taxes – ΔWorking Capital – CapEx + Net Borrowing

Here, we’re essentially figuring out how close a company’s discretionary free cash flow gets to its EBITDA. In contrast, “bad” FCF conversion would be well below 100% – and can be particularly concerning if there has been a distinct pattern showing deterioration in cash flow quality year-over-year. The objective here is to compare a company’s free cash flow (FCF) in a given period to its EBITDA, in an effort to better understand how much FCF diverges from EBITDA. In most cases, it’s pointless to walk through these bridges because these metrics are typically used for valuation purposes, such as in a DCF model, and you rarely build an entire DCF starting from EBITDA. Unfortunately, many of the online tutorials for this topic skip the subtleties ebitda to fcf in the calculation and gloss over issues like lease accounting. In investment banking interviews, it’s common to get questions about different ways to calculate metrics such as Free Cash Flow.

A Comprehensive Guide for Accounting Students and Auditors

• FCFE is good because it is easy to calculate and includes a true picture of cash flow after accounting for capital investments to sustain the business.
• As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy.
• EBITDA sometimes serves as a better measure for the purposes of comparing the performance of different companies.
• These measures offer critical insights into different, but both important, aspects of a company’s management, profitability, ability to generate revenue, and availability of cash.
• In this blog, we will dive deeper into their definitions, calculations, and applications and guide you on when and how to use them effectively in financial decision-making.

It’s supposed to be a proxy for a company’s Cash Flow from Operations, because just like with CFO you add back D&A and ignore CapEx. So EBITDA, theoretically, should be close to the company’s recurring cash flow generated by its core business operations. EBITDA is often used in valuations, mergers, and acquisitions to compare companies regardless of capital structure, while FCF highlights the funds available for reinvestment or debt repayment. In this blog, we will dive deeper into their definitions, calculations, and applications and guide you on when and how to use them effectively in financial decision-making. FCF conversion is measured by comparing free cash flow to a company’s net profit. To calculate FCF conversion, divide free cash flow by the company’s net profit.

For example, when a customer buys products on credit, it will be calculated as sales and included in revenue, but the company will not receive actual cash on hand. Here is free cash flow conversion tells us about a company’s effectiveness in converting its profit into cash. Free cash flow conversion is a liquidity ratio used by both investors and the management team to manage cash flow effectively. As we can see, the adjusted FCF of the company is higher than the unadjusted FCF, as the non-cash items and changes in working capital have a positive net effect on the cash flow of the company. This shows the importance of avoiding common pitfalls and errors when using EBITDA to FCF conversion, as they can lead to misleading or inaccurate results.

Capital Expenditures’ Role

But EBITDA became the metric of choice for private equity practitioners in the 80s, and its use has expanded ever since. EBITDA is one of the most common metrics used to arrive at valuation, especially in the context of private equity transactions. It is also frequently used to develop the capital structure for a transaction. Finally, it is frequently cited as a proxy for cash flow, which is dangerous if you don’t understand the difference between the two. Efficient working capital management involves striking a balance between these elements. Companies often employ strategies such as just-in-time inventory systems to minimize inventory levels and improve cash flow.

If so, that’s very positive because it means the company gets more cash earlier on, on a consistent basis. Net borrowing is also referred to as net debt and can be found on the balance sheet under “Cash from investing”. Intelligent Reconciliation engine to match planned cash transactions with actual bank statements. Corporate venturing is a strategic approach adopted by companies to foster innovation and drive… Learn more about how an ESOP can help you get the best value at sale for the business you’ve spent a lifetime building.

Free Cash Flow to the Firm or FCFF (also called Unlevered Free Cash Flow) requires a multi-step calculation and is used in Discounted Cash Flow analysis to arrive at the Enterprise Value (or total firm value). FCFF is a hypothetical figure, an estimate of what it would be if the firm was to have no debt. The claim of debt shareholders can be on $70 of the firm’s capital in the case of liquidation or sale. One final wrinkle is the issue of lease accounting and how the rules changed when IFRS 16 and ASC 842 were implemented in 2019. You must understand the type of Free Cash Flow you are calculating and the items it should deduct – if you know that, you’ll be able to calculate it starting with any metric.

Whether it’s comparable company analysis, precedent transactions, or DCF analysis. Each of these valuation methods can use different cash flow metrics, so it’s important to have an intimate understanding of each. EBITDA can be easily calculated off the income statement (unless depreciation and amortization are not shown as a line item, in which case it can be found on the cash flow statement). As our infographic shows, simply start at Net Income then add back Taxes, Interest, Depreciation & Amortization and you’ve arrived at EBITDA. While FCF provides a more comprehensive view of a company’s cash-generating ability, EBITDA can be useful for comparing operational performance across companies with different capital structures and tax situations.

Free cash flow is an important measure of how well-positioned a company is to pay down debt or make strategic investments that could improve its competitiveness. This is an important consideration, especially within rapidly changing market landscapes. By comparing a company’s available free cash flow to an operating metric, the FCF conversion rate helps evaluate the quality of a company’s cash flow generation. Additionally, FCF is a critical metric for assessing a company’s ability to generate cash for dividends, share buybacks, and debt repayment. Companies with strong FCF are often seen as more financially stable and capable of weathering economic downturns.