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.

EBITDA Is Not Cash Flow

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.

Free Cash Flow

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.³ 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.

A Study in Correlation

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.⁴ 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.

An Integrated Approach

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.

---

Footnotes

¹ Joe Sciametta is a restructuring professional whose experience includes both debtor and creditor representations. Return to article

² 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. Return to article

³ Helfert, Erich A. D.B.A., Techniques of Financial Analysis: A Modern Approach, Ninth Edition, Irwin. Return to article

⁴ The authors thank Angela Tsai for her assistance with the preparation of the analysis. Return to article