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EBITDA Is Not A Good Proxy For Cash Flow

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Do not say “EBITDA is a good proxy for cash flow”1

I worked as a cash flow lender for quite awhile and never heard a colleague at our institution ever say anything to that effect.  In the business world, I do hear the folks make the simplification.  It’s a shortcut that can get you in trouble.

I am a firm believer that you can tell a lot about a person’s knowledge of financial statements by understanding where they focus their attention.  More on this later.  

However, I find that managers, business unit leaders, and maybe even C level executives tend to spend a lot of time on the income statement, and not much else.  And when focusing on the income statement (a.k.a., P&L, profit & loss), most attention is paid to revenue and EBITDA (earnings before interest, taxes, depreciation, and amortization).  Also, business folks like to adjust EBITDA by removing non-operating items or other one-time, non-recurring items.

Again, I am not going to opine on how I utilize financial statements right now or where I spend the majority of my time.  But the other statements are there for a reason.  The balance sheet and statement of cash flows provide information not available on the income statement.

But let’s address why you should not make the statement that “EBITDA is a good proxy for cash flow.”

EBITDA is a good proxy for operating income.  It focuses the readers of the financial statements on what generally accepted accounting principles (GAAP) say the accounting profit (or loss) of the business is for the period.  It does this by ignoring certain items (i.e., push them below the line):

  1. Interest – interest is typically paid on debt.  Debt is a financial engineering / capital structure decision for most businesses, not an operational one.  Also, some companies have debt and others don’t.  Setting aside interest payments helps look at the operations of the business regardless of capital structure.
  2. Taxes – a note of caution here, read your debt covenants carefully, as this is generally read as income taxes.  In my opinion, taxes such as commercial activity taxes and other “taxes and fees” are very much a part of operations and most lenders agree.  However, taxes on income can be heavily influenced by interest payments, depreciation, amortization, and other deductions.  So, setting income taxes aside let’s you focus on the operations of the business, without those distortions.
  3. Depreciation – this one is a bit more murky in my mind.  However, depreciation on capital spending is generally considered not part of operations.  And it is highly dependent on the type of business and accounting policies in place.  
  4. Amortization –  this one can be extremely murky as well.  Commonly, intangible assets and goodwill, such as those created during an acquisition, lead to amortization.  Also, capitalizing certain software development costs can also create amortization.  And with the introduction of ASC 606, capitalizing certain contract costs (i.e., commissions) will create amortization.  I personally have some difficulty calling some of these non-operational – especially software companies that capitalize software development costs or really any commission expense based on selling contracts (please show me something more operational than selling your products).  But typically all amortization is excluded from EBITDA.
  5. Non-Operational Adjustments – oh, what a slippery slope this one can be.  But many “non-recurring” items are excluded or “added back” when calculating EBITDA, creating “adjusted EBITDA”.

But EBITDA may not approximate cash flow for quite a few reasons.  It’s also a little unclear what people mean when they say “cash flow”.  The cash flow statement has three major sections: 

  1. Cash Flow from Operations
  2. Cash Flow from Investing
  3. Cash Flow from Financing

But setting that aside, the cash flow statement is explaining why the amount of cash changed and by how much.  So let’s stick with that spirit and ask is EBITDA a good proxy for “the changes in cash” in a business.

Like all things, it depends on the business a bit, but let’s look at a few elements excluded from EBITDA that can help explain why EBITDA does not serve as a good proxy for cash flow:

  1. Interest – debt investors generally like to be paid in cash.  Bummer, I know.  So, depending on how much cash interest is being paid, this one can cause EBITDA and cash flow to diverge pretty substantially.
  2. Taxes – yep, Uncle Sam, likes cash too.
  3. Depreciation – generally non-cash, but the thing that causes depreciation, capital spending, typically involves cash.  Capital spending does not show up on the income statement.
  4. Amortization – many of these items are non-cash, although some are cash events.  Software developers, regardless of whether you are electing to capitalize their salary expense, typically like to be paid in cash.  And, so do sales people.  Especially sales people.
  5. Non-Operational Adjustments – yep, many of these are cash events, regardless of whether or not you consider them operational.  Shove enough cash events “below the line” and you will create some large variances.

What else could cause EBITDA and cash flow to diverge?  Here are a few big ones.

  1. Subscriptions – many subscriptions are billed in advance.  So the company receives all the cash upfront, and then ratably recognizes revenue over the term of the agreement.  Depending on the term and how it spans reporting periods, this can create some really large variances between EBITDA and cash flow.  For example, let’s say a company signs a one year subscription agreement for $100,000 with a customer on July 1, 2021 through June 30, 2022.  According to the terms of the agreement, the customer will pay upfront.  
Revenue / EBITDA$50,000$50,000
Cash Flow$100,000$0

Side note: You can see why in a growing subscription business, cash flow would be overstated vs. a business in more of a steady state stage.  Also, you can see where a declining subscription business could encounter some cash flow issues not apparent by only looking at the income statement.

  1. Prepaid Expenses – same concept as above but with expenses.  The company pays upfront, but ratably recognizes the expenses over some longer period.
  2. Accruals – this whole article is predicated on using the accrual based accounting method.  So, let’s say you accrue year end incentives but pay those out some time after year end.  Depending on how large those are (they are high six figures in most my businesses), that will cause EBITDA and cash flow to look different.
  3. Distributions – this one is a bit grey based on the definition of cash flow, but if a business is making distributions to owners / shareholder (i.e, dividends), these are not going to show up anywhere on the income statement.  Those types of activities show up in the Cash Flow from Financing section and are generally not considered operational.  However, it does mean you could have a business where EBITDA is significantly higher than cash flow depending on the size of the payments.
  4. Financing Events – either selling securities or redeeming them won’t show up anywhere on the income statement.  Similar to distributions, these events are not considered operational.  But they certainly impact cash flow.

I guess you could amend the original statement to say “operating cash flow”, but I would argue, this just makes you less wrong.

So, I would encourage you never to say “ EBITDA is a good proxy for cash flow.”  Instead, avoid the shortcut altogether, and get to know the statement of cash flows.

  1. This article is predicated on using the accrual based accounting method.