The problem with any measure from the P&L statement (such as EBITDA, EBIT and NPAT) is that they rarely represent cash flow. Cash flow is important because we like to understand returns from a cash, rather than paper, perspective.
However, measuring maintainable cash flow from the financial statements can be inaccurate and difficult, especially with public companies. Therefore, we are often relegated to using P&L measures.
EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization) shows operating profit without the non-cash charges. It is what purists might call a measure of pure operating profitability.
EBIT (Earnings Before Interest and Tax) includes depreciation and amortization, so it partially accounts for capital intensity.
In practice, here is what matters: EBITDA has no provision for capital expenditure. For a capital-intensive business, EBITDA can be wildly misleading. That m EBITDA figure means little if the company needs m in annual capex just to maintain its assets.
EBIT is better because depreciation often approximates smoothed capex over time. It is not perfect, but it is closer to economic reality.
The classic error is using EBITDA for capital-intensive businesses. I have seen deals where headline EBITDA looked attractive, but maintenance capex consumed nearly all of it. The real cash generation was a fraction of the reported number.
Another mistake is ignoring working capital changes. Neither EBITDA nor EBIT captures the cash tied up in inventory, receivables, or payables.
Explore more on free cash flow analysis and capex considerations.
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Due Diligence, EBITDA
When we talk about working capital in private equity, we may be referring to the financial monitoring value (current assets – current liabilities) or the financial analysis value (current assets – cash – current liabilities). When monitoring a business, we want to know if it is solvent; that is, whether the business can cover its
Read MoreTo recap, we care about working capital because it is a direct driver of free cash flow and everyone loves free cash, ergo, everyone cares about working capital. But, before we talk about improving working capital, it’s important we understand how to measure and monitor it. If we measure it in a consistent way, we’ll
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