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
The working capital profile of a business can either deliver an ongoing surplus of cash (above earnings) or can cause an ongoing drain of cash (below earnings). This first diagram shows a situation in which there’s a cash drain on the business in question. If the business is selling its goods for more than it
Read MoreCapital Expenditure (Capex), which simply means expenditure on assets with long lives, is a big deal for private equity. Firstly, because it reduces cash flow. Secondly, because it reduces cash flow. Thirdly, okay, okay… I don’t want to harp on about cash flow, but I do want to talk about the importance of capital expenditure
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