EBITDA vs. Cash Flow: What Business Owners Need to Know

EBITDA is often used as shorthand for cash flow, but nothing could be further from the truth. EBITDA, or earnings before interest, taxes, depreciation, and amortization, is a metric that many believe reflects cash flow. What may have started as a rough estimate of cash flow for a specific industry has evolved into a widely used valuation metric across all businesses, leaving many scratching their heads. In our view, EBITDA does not accurately reflect cash flow for several reasons.

EBITDA was first conceived in the 1970s and gained momentum as a valuation metric in the 1990s. The industry that popularized this approach was cable TV operators. These companies were investing massive sums to lay fiber to homes, a large one-time cost. Once installed, ongoing maintenance costs were minimal, and customers were typically “sticky,” with limited alternatives. Consequently, depreciation appeared as a significant deduction on the income statement but was added back on the cash flow statement because it is a non-cash expense. After the fiber installation, capital expenditures dropped dramatically, far below the reported depreciation.

Income taxes were not an issue for cable operators, as the large depreciation expense often left them with little or no net income. Without net income, taxes were minimal. Furthermore, working capital in the cable industry contributed positively to cash flow, unlike most other businesses where cash is often paid before revenue is received. This distinction helped justify the use of EBITDA in that specific context.

Consider a simplified example of a cable company’s income statement and cash flow statement:

Income Statement:
EBITDA: $10,000,000
Depreciation and Amortization: $8,000,000
Interest: $3,000,000
Taxes @ 25%: $0 (due to tax loss carryforwards)
Net Income: -$1,000,000

Cash Flow:
Net Income: -$1,000,000
Depreciation and Amortization: $8,000,000
Working Capital: $1,000,000
Cash Flow: $8,000,000
Capital Expenditures: -$1,000,000
Owner Earnings: $7,000,000

In this example, EBITDA ($10,000,000) minus interest ($3,000,000) roughly aligns with owner earnings ($7,000,000), making EBITDA a reasonable proxy for cash flow in that industry at that time.

For most other businesses, however, EBITDA does not reflect cash flow accurately. Several factors contribute to this discrepancy. First, the capital structure affects cash flow. If a business carries debt, interest payments reduce available cash, meaning EBITDA overstates cash flow. While debt itself is not inherently bad, it comes at a cost.

Second, taxes matter. Businesses generating net income must pay taxes, which reduces cash flow. Cable companies were largely exempt from taxes due to depreciation, but most businesses outside cable or real estate must account for taxes, lowering owner earnings relative to EBITDA.

Third, depreciation and amortization can be misleading. While amortization is a non-cash expense that can reduce taxes, depreciation represents past investments in equipment, tools, and facilities and often signals ongoing or future capital needs. In a steady-state business, depreciation generally approximates capital expenditures; in growth phases, capital expenditures may exceed depreciation. Either way, these costs reduce owner earnings but are added back in EBITDA.

Fourth, working capital is critical but invisible on the income statement. Accounts receivable, accounts payable, and inventory levels create the business’s cash flow cycle. Short payables, long receivables, and high inventory create negative cash flow, while long payables, short receivables, and minimal inventory improve cash flow. These dynamics can significantly affect owner earnings but are not captured by EBITDA.

If EBITDA truly represented cash flow, it would simply be called cash flow.

Here is an example for a typical business:

Income Statement:
EBITDA: $10,000,000
Depreciation and Amortization: $3,000,000
Interest: $1,000,000
Taxes @ 25%: $1,500,000
Net Income: $4,500,000

Cash Flow:
Net Income: $4,500,000
Depreciation and Amortization: $3,000,000
Working Capital: -$1,000,000
Cash Flow: $6,500,000
Capital Expenditures: -$3,000,000
Owner Earnings: $3,500,000

In this scenario, owner earnings of $3,500,000 differ significantly from EBITDA of $10,000,000. For these reasons, we are cautious about using EBITDA as a valuation metric. If EBITDA is used, it is essential to track actual cash flow and develop a clear understanding of owner earnings.

If this concept resonates or you would like to discuss your business further, please contact me directly at [email protected].