Wherein lies the difference between EBITDA and free cash flow?
The question "What is the difference between EBITDA and free cash flow?" comes up frequently, because both figures show the earning power of a company. We would like to explain why EBITDA and free cash flow are not the same and why they can differ greatly from each other.
EBITDA (earnings before interest, taxes, depreciation and amortisation) and free cash flow (FCF) are very similar, but not the same. Rather, they represent different ways of showing a company's earnings, which gives investors and company managers different perspectives.
EBITDA indicates revenue before taxes, interest payments and depreciation are deducted. Furthermore, EBITDA does not include capital expenditures. In free cash flow, on the other hand, all depreciation and changes in working capital and capital expenditures are added to the revenues and interest and tax payments are deducted. In contrast to EBITDA, only the freely available cash elements that a company still has available after deducting all expenses (taxes, interest, etc.) are shown.
It follows from the definitions in the above section that EBITDA includes the cash flows of a company, but it also includes other non-cash elements. If the cash flow is only measured on the basis of the EBITDA value, there can therefore be major differences to the actual free cash flow.
It is better to calculate cash flow separately and not equate it with EBITDA if you want to get the most accurate picture of a company.
You can convert the free cash flow into EBITDA and vice versa. Once you have the value for EBITDA, you calculate all non-cash elements from it to get the FCF:
FCF = EBITDA - Interest - Taxes - Changes in working capital - capital expenditures + net borrowing
All values can be found on the balance sheet. Net borrowing is also referred to as net debt and can be found on the balance sheet under "Cash from investing".
In the same way, the FCF can be used to calculate the EBITDA value by simply rearranging the formula above:
EBITDA = FCF + Interest + Taxes + Changes in working capital + capital expenditures - net borrowing
The FCF can be put into relation with the EBITDA. This ratio then indicates how efficiently a company converts its EBITDA into cash:
FCF-to-EBITDA ratio = FCF / EBITDA
The higher this value, the more efficiently the company converts its EBITDA into cash. If this value is very low, it can be an indication that the working capital is not working efficiently enough in the company.
This is the case, for example, if customers pay their invoices very late (a high value for days sales outstanding), or if a lot of capital is tied up in inventory.
Free cash flow can be higher or lower than EBITDA. In each case, it depends on the circumstances in the company, which expenditures were made. If the changes in working capital within a financial year are strongly positive because e.g. a large investment was made, the free cash flow can be less than EBITDA.
If, on the other hand, the changes in working capital are strongly negative, e.g. because a company has received high advance payments from customers but has not yet rendered any services in return, the free cash flow can be higher than EBITDA.
We now see that EBITDA and free cash flow are similar to each other, but their figures can differ greatly. If you want to evaluate the cash flow of a company as accurately as possible, EBITDA is an unsuitable figure because it includes items that do not count as cash flow.
If, on the other hand, you want to compare your company with other companies, EBITDA is more suitable. Since interest, taxes and depreciation are neutralised, it allows for more accurate comparisons of companies from different countries, since e.g. taxation is not taken into account. You can then assess how high the earning power of your company is compared to your international competitors.
The difference between EBITDA and Free Cash Flow is therefore to look at the revenues of a company from different angles. Depending on which goal one is pursuing, EBITDA or free cash flow is more suitable for consideration.