Free cash flow (FCF) and earnings before interest, tax, depreciation and amortization (EBITDA) are two different ways of looking at the earnings generated by a business. There has been some discussion as to which is the better measure to use in analyzing a company.
Free cash flow is unencumbered. Analysts arrive at free cash flow by taking a firm’s earnings and adjusting it by adding back depreciation and amortization expenses. Then deductions are made for any changes in its working capital and capital expenditures. They consider this measure as representative of the level of unencumbered cash flow that a firm has to work with.
EBITDA, on the other hand, represents a company’s earnings before taking into account essential expenses such as interest payments, tax payments, depreciation, and certain capital expenses that are being accounted for, or amortized, over a period of time. Also, EBITDA doesn't take into account capital expenditures, which are a source of cash outflow for a business. These are amounts that are really not available to the firm. (For more, see: What is the formula for calculating EBITDA?)
Mergers and Acquisitions
In mergers and acquisitions, many times firms use debt financing, or leverage, to fund the acquisitions. In such cases, free cash flow may not provide the best way of comparing firms that have taken on a lot of debt that they need to pay interest on, and those that haven’t. However, EBITDA provides a better idea about the capacity of a firm to pay interest on the debt it has taken on for an acquisition through a leveraged buyout. Also, EBITDA provides a way of comparing the performance of a firm prior to a leveraged acquisition and after the acquisition, for which it might have taken on a lot of debt that it needs to pay interest on.
EBITDA For Comparisons
EBITDA may also serve better to compare the performance of different firms. Considering that capital expenditures are somewhat discretionary and could tie up a lot of capital, EBITDA provides a smoother way of comparing companies. And some industries, such as the cellular industry, require a lot of investment in infrastructure and have long payback periods. In these cases too, EBITDA may provide a better and smoother basis for comparison by not adjusting for such expenses.
FCF For Individual Companies
However, when it comes to analyzing the performance of a company on its own merits, many analysts see free cash flow as the better measure. This is because it provides a better idea of the level of earnings that is really available to a firm after it meets its interest, tax, and other commitments.
There is less scope for fudging free cash flow than there is to fudge EBITDA. For instance, the telecom company WorldCom got caught up in an accounting scandal when it inflated its EBITDA by not properly accounting for certain operating expenses. Instead of deducting those costs as everyday expenses, WorldCom accounted for them as capital expenditures so that they were not reflected in its EBITDA.
And when it comes to valuing a company – which involves discounting the cash flow it generates over a period of time by a weighted average cost of capital that accounts for the cost of debt funding, as well as the cost of equity – a company’s free cash flow serves as a better measure.
The Bottom Line
Free cash flow and EBITDA offer two ways of analyzing a company. EBITDA sometimes serves as a better measure for purposes of comparing the performance of different companies. Free cash flow is unencumbered and may better represent a company’s real valuation.