Analysts use a number of metrics to determine the profitability or liquidity of a company. Earnings before interest, taxes, depreciation, and amortization (EBITDA) is often used as a synonym for cash flow, but in reality, they differ in important ways.
EBITDA became popular in the 1980s with the rise of the leveraged buyout industry. It was used to establish a company's profitability relative to companies with similar business models, as well as a measure of a company's ability to service debt. Because this metric is not defined under the generally accepted accounting principles (GAAP), the calculation varies from company to company. However, the basic formula is operating income, which is net revenue less operating expenses and cost of goods sold, with depreciation and amortization added back in. EBITDA aims to establish the amount of cash a company can generate before accounting for any additional assets or expenses not directly related to the primary business operations.
Prudent Cash Flow
In reality, however, a company's liquidity is very much affected by things such as loan interest, investment income, and taxes. Prudent cash flow management accounts for all funds coming in and going out of a business during a given period, so the calculation of cash flow is inherently different from that of EBITDA. Many companies require a large amount of capital expenditure for heavy equipment or specialized facilities. The facilities and equipment depreciate over time and require upkeep and occasional replacement. These types of expenses are incorporated into the calculation of cash flow but not EBITDA. Because it neglects many kinds of expenses, a quick look at EBITDA can make a company look more liquid than it is. Cash flow is a much more comprehensive metric, and it provides a more reliable measure of a company's financial health.