Journal Issue:
Mar 2003
Column Name:
Financial Statements
Journal Article:
On the evening of June 25, 2002, the financial networks werereporting one story: WorldCom! Various networks and commentators were eachreporting that WorldCom's cash flow had been overstated by $3.3 billion.That news was enough to make any auditor cringe; after all, they were talkingabout cash, not off-balance sheet financing or special purpose entities. Cashis, well, cash. The Statement of Cash Flows should tie to the balance sheetthrough a simple reconciliation process.
As the networkscontinued to report, it became clear that WorldCom's cash flowwasn't overstated. Instead, the company had misclassified certainexpenses, which led to greater EBITDA. The network reporters—educatedmembers of the financial community—were incorrectly using the terms EBITDAand cash flow interchangeably.
EBITDA Is Not Cash Flow
EBITDAis defined as Earnings Before Interest Taxes Depreciation and Amortization. Itis a measure of operating results that has gained popularity with the investingcommunity over the years because it removes certain large non-cashexpenditures from the results reported on a company's Statement ofOperations (P&L) to arrive at a number that more closely resembles thecompany's cash flow. It gained increased popularity as a measure in themid-80s as a result of the great number of corporate acquisitions at multiplesin excess of book value. The acquisitions created substantial amounts ofgoodwill on corporate balance sheets. In accordance with the generally acceptedaccounting principles (GAAP) that were in effect at the time, this goodwill wasamortized against future operating results. Many companies reported largebottom-line losses as a result of the non-cash charges. EBITDA removed thesecharges, creating a rosier picture for investors trying to gauge a company'sfinancial strength. Although it is conceptually a better indication of cashflow than net earnings or operating income, EBITDA is not synonymous with cashflow.
EBITDA as a measurefalls short of cash flow for many reasons. First, it makes no allowance for theamount of capital expenditures made by a firm in a given period. Capitalexpenditures, real cash outflows, are recorded on the balance sheet andrecognized as expenses in later periods. This is consistent with what inaccounting is referred to as the matching principal, where expenses arereported in the periods in which the related revenue is generated or the assetis consumed. For this reason, large capital expenditures are not recognized onthe P&L in the period in which they are made, and therefore not reflectedin that period's EBITDA. Furthermore, under GAAP, capital expendituresare depreciated in subsequent periods and never reflected in EBITDA. Capitalexpenditure requirements can put a great deal of stress on a firm'scapital structure and threaten its viability.
Second,EBITDA also makes no provision for the effectiveness of a firm in managing itsworking capital. EBITDA normally ignores a firm's ability to manage itsreceivables and payables, and collect cash. As a result, EBITDA ignores the qualityof a firm's customer base and the non-interest bearing financing obtainedthrough vendor credit. Finally, non-cash earnings such as those resulting frombarter transactions can inflate EBITDA. Although these transactions can createvalue, they have no impact on a firm's cash flow.
Third,EBITDA does not account for quality of earnings. Many industries that servicelong-term contracts book revenue based on a percentage of completion. Revenueis recognized as costs that are incurred on a project. If 1/3 of estimatedtotal costs have been expensed, 1/3 of estimated total revenue is booked withan unbilled receivable appearing on the company's balance sheet. Once theproject is complete or a billing milestone is reached, the unbilled receivableis billed to the customer, and cash is collected. Depending on the duration ofthe construction project, revenue and EBITDA may appear robust, while thecompany struggles to meet its current obligations due to the working capitalcrunch.
Free Cash Flow
Thereis a measure of operations currently being used that bears a closer resemblanceto a firm's cash flow than EBITDA, and that is Free Cash Flow (FCF). Inits simplest form, FCF is the net amount of (1) reported profit, adjusted fordepreciation, depletion and other non-cash accounting elements, less (2) newinvestment in facilities, and plus or minus (3) changes in working capital.3FCF not only incorporates cash outflows associated with capital expenditures,but also captures a firm's ability to effectively manage its workingcapital.
FCFas a measure is less impacted by management discretion and accounting treatmentof transactions than EBITDA. For example, the management team ofWorldCom's decision to treat various cash expenditures as capitalexpenditures rather than operating expenses would have had no impact on thecalculation of World-Com's FCF.
Forthese reasons, FCF is a better indicator of a firm's ability to generatecash, its related viability and ultimate value than EBITDA.
A Study in Correlation
Thecorrelation between EBITDA and FCF varies depending on many factors including acompany's industry and life cycle. For example, start-up enterprises andhigh-technology businesses tend to have large amounts of capital investment. Inthese environments, FCF and EBITDA have a low correlation. When analyzing theviability of these businesses, EBITDA is extremely misleading because itignores the large amounts of cash required to support the growth andtechnological development of these businesses.
Inpreparing this article, the authors analyzed the correlation between FCF andEBITDA for 42 companies recently emerging from or currently under chapter 11bankruptcy protection.4 The analysis compared the results of operations for thelast fiscal year immediately preceding each company's petition date asmeasured by both FCF and EBITDA.
Theresults of this study showed that while more than 33 percent of these companieshad positive EBITDA, they had negative FCF. In analyzing the pre-petitionviability of these companies, operations as measured by FCF would have been abetter measure than EBITDA. A positive EBITDA would not have been a truepicture of the cash demands on these businesses.
Thestudy also showed that the correlation between the two measures greatly variedby industry. For example, the EBITDA and FCF margins for the telecom industrywere -0.8 percent and -31.9 percent respectively, whereas these same marginsfor the manufacturing and retail industry were 1.6 percent and -1.6 percent,respectively.
Thelarge variance in the telecom industry data can primarily be attributed tolarger capital expenditures pertaining to the build-out of networks anddevelopment of technologies. On average, of the 13 telecom companies includedin the study, annual capital expenditures for the last fiscal year precedingthe chapter 11 filing was more than 42 percent of annual revenues, whereas itwas less than 4 percent for the 16 manufacturing and retail companies includedin the study.
Inaddition, EBITDA, as compared to FCF, has been inflated due to thevendor-financing deals, non-cash IRU transactions and other bartertransactions prevalent in the telecom industry. These transactions generatedEBITDA, but had less impact on FCF.
Asdemonstrated in the accompanying chart, EBITDA consistently reported betterpositive results or less negative results when measured against FCF.
An Integrated Approach
AlthoughFCF is often a better measure than EBITDA in analyzing the results ofoperations for any business, there is an inherent danger in using any onemeasure in assessing a firm's value and viability.
FCFas a measure does reflect the pressure of capital investment, working-capitalefficiency and quality of a firm's earnings; however, it ignores otherthreats to a firm's viability, including its ability to service theinterest and principal obligations of its existing capital structure. AlthoughFCF may reflect sufficient cash to fund existing operations and requiredcapital investment, if the amount of FCF is not sufficient to satisfy afirm's existing obligations, the viability of the business may be inquestion.
For these reasons, a single measure of operating performance is insufficient. Asimple, yet more integrated approach is necessary. A reasonable analyst doesnot rely on any one single indicator, especially in given industries. Whenassessing the value and viability of a company, it is important to use anintegrated approach that not only includes items from the P&L and Statementof Cash Flows, but also includes an assessment of the strength ofcompany's balance sheet and ability to meet existing obligations.
Footnotes
1 JoeSciametta is a restructuring professional whose experience includes both debtorand creditor representations. Return to article
2 JackKloster is a manager in Huron Consulting Group's Corporate AdvisoryServices practice. Jack's restructuring experience includes debtor andcreditor representations for telecom, health care and manufacturing companies. Return to article
3 Helfert,Erich A. D.B.A., Techniques of Financial Analysis: A Modern Approach, Ninth Edition, Irwin. Return to article
4 Theauthors thank Angela Tsai for her assistance with the preparation of theanalysis. Return to article
