What is EBITDA?

EBITDA is probably the most common non-GAAP metric that companies report. It is a rough guide to show how much cash a business generates.

EBITDA is an acronym for earnings before interest, taxes, depreciation, and amortization.

EBITDA is a major financial indicator used to evaluate companies' profitability with different capital structures.

The cable industry pioneer John Malone developed the metric in the 1970s to sell investors on his company’s true profitability, which he believed was not accomplished by GAAP figures such as earnings per share.

How is EBITDA calculated?

Calculating EBITDA requires information from a company's income statement and cash flow statement.

Here's one way to do it:

Net Income

+ Interest Expense (Income Statement)

+ Taxes (Income Statement)

+ Depreciation (Cash Flow Statement

+ Amortization (Cash Flow Statement)

Pros and Cons of EBITDA

EBITDA gives investors a quick snapshot of a company's profitability. It is also an excellent tool for comparing and evaluating companies with different capital structures.

But, because EBITDA does not consider all business activities, it might overstate cash flow.

For instance, it backs out depreciation and amortization as expenses.

Depreciation is when a tangible asset's value is gradually reduced over time to account for wear and tear. For instance, a new piece of factory equipment is worth more than it will be after years of heavy use.  

What depreciation is for a physical asset, amortization is its counterpart for intangible assets, usually financial instruments like a loan.

Usually, when companies report non-GAAP results, they back out depreciation and amortization because no cash is leaving the company based on either of these metrics when the report is made.

However, factory equipment needs to be replaced eventually, so depreciation is a very real expense over the life of a business.

What is Free Cash Flow?

Free cash flow is found using the cash flow statement.

The purpose of the cash flow statement statement is to track cash movement. It shows how cash moves through a company over a period of time, such as a quarter or year.

A company’s cash flow statement can be compared to your personal checking account. It doesn’t care about transactions of goods and services being sold or when sales contracts are signed. It only tracks when money is deposited or withdrawn from a company’s bank accounts.

Cash flow statements use cash accounting, not accrual accounting.

The cash flow statement begins with net income as its input before non-cash charges are added back. These charges were accounted for on the income statement but where no cash exchanged hands.

This commonly includes four things:

1) Amortization - The gradual writing off of an intangible asset, similar to paying more interest at the start of a mortgage.

2) Depreciation - The gradual writing off of a tangible asset, such as the value of your car decreasing over time.

3) Stock-based compensation - Compensating employees with stock instead of cash.

4) Asset impairment - When the market value of an asset is less than previously stated and is written down, such as a company admitting it paid too much for an acquisition.

These charges are accounted for on the income statement (though they are not always broken out), but none involve cash leaving a company’s bank account.

Continuing with operating activities, changes in working capital are the difference between current assets and current liabilities (both from the balance sheet). This can include accounts receivable (e.g., when someone pays for a good or service using credit), inventory that has yet to be sold, or prepaid expenses.

After accounting for non-cash charges and changes in working capital, this gives us operating cash flow. It is the cash generated from normal business operations, similar to net income from the income statement on a cash basis.

Free cash flow results from subtracting capital expenditures (CapEx) from operating cash flow. CapEx are funds a company uses to build new or maintain existing physical assets, such as factories, equipment, and machinery.

In other words, free cash flow measures the amount of cash a business generates (using cash accounting) after subtracting all operating expenses and capital expenditures.

Pros and Cons of Free Cash Flow

Because free cash flow directly measures the cash generated by a company's operations, it is a terrific measure of its ability to pay off debt and return capital to shareholders.

Free cash flow is also more difficult for management teams to manipulate than EBITDA.

But free cash flow can also be volatile, fluctuating wildly from year to year as spending cycles and capital expenditure needs ebb and wane.