By Charles W. Mulford
Earnings before interest, taxes, depreciation and amortization, or EBITDA, is a metric that is often used in loan underwriting decisions for small business. This is understandable as EBITDA provides a measure of cash flow that is easily calculated for borrowers that are less likely to provide more sophisticated cash flow information.
When used properly, there is no reason to replace EBITDA in loan underwriting decisions. It provides a very useful measure of earnings that are available for servicing interest on debt.
As a measure of cash flow, however, EBITDA is somewhat crude and leaves much to be desired for underwriting decision making.
The problem with EBITDA, unlike more sophisticated measures of cash flow, is that it does not take into account changes in working capital balances. A company may be generating ample amounts of EBITDA, but because of growing accounts receivable or inventory balances, for example, it may not be generating any actual cash flow that can be used to service debt. Introduce some collection problems or a slowing in inventory turnover, for example, and cash flow as measured by EBITDA will immediately start to dry up.
Another problem associated with using EBITDA is that it only measures the cash available to cover the interest requirements of debt. Both interest and taxes must be deducted before calculating the amount of cash flow that is available for addressing the principal component of debt service.
Theoretically, introducing the simplifying assumptions of no growth and no changes in underlying working capital turnover would make EBITDA a decent cash flow metric. However, those are rather stringent simplifying assumptions. Even marginal growth leads to increases in working capital balances that consume cash and potentially renders a firm unable to service its debt. A deterioration in working capital turnover would consume even more cash.
Even with the simplifying assumptions of no growth and no changes in working capital turnover, EBITDA does not provide a measure of cash flow that can be used to service principal on debt.
Alternative Ways of Measuring Cash Flow
Instead of replacing EBITDA when evaluating small businesses, one useful approach is to supplement it with additional information. For this purpose, free cash flow is a very effective choice for gaining insight into a borrower’s ability to service debt, including both interest and principal.
Free cash flow is relatively easy to calculate, even for a small business, by subtracting interest and depreciation from EBITDA, and by adjusting it for changes in working capital and for capital expenditures. Because it takes changes in working capital into account, free cash flow is a cash flow and not an earnings metric. Further, because it is calculated after interest and taxes, free cash flow provides a cash flow measure that is available to service even the principal requirements on debt.
Finally, free cash flow can be viewed as a sustainable measure of cash flow because it is measured after capital expenditures, accounting for the replacement and renewal of a borrower’s productive capacity.
Identifying Strong Companies That Still Have Borrowing Needs
Companies that generate free cash flow sufficient to cover the principal requirements of debt service are in a truly enviable position. They are able to cover all of their cash needs with internally-generated cash flow while providing for replacement of productive capacity consumed by operations. While these companies can provide for the growth requirements of working capital and capital expenditures, they often do not need to borrow to grow operations.
Generating positive free cash flow while covering the growth requirements of working capital and capital expenditures is an outcome that is likely difficult for most borrowers to achieve. As a result, this may be a superior measure of a company’s financial health, but it may not be effective at identifying firms that are financially sound but still have borrowing needs.
What a lender might consider is a fallback position: free cash flow measured before the growth requirements of working capital and capital expenditures are taken into account. Using this metric, only the non-growth changes in working capital and capital expenditures are used in the calculations. That is, cash flow is calculated for changes in working capital that are caused by changes in working capital turnover, as well as capital expenditures that merely maintain productive capacity without growing it. Such a measure of free cash flow leaves the cash flow requirements of growth to be financed separately, but can still effectively evaluate a borrower’s ability to service both the interest and principal requirements of debt.
When Evaluating Small Borrowers’ Cash Flow, Look Beyond EBITDA
For small borrowers, EBITDA has its place as a measure of earnings that are available for servicing the interest requirements of debt service. It is not, however, a true measure of cash flow. Instead, free cash flow is an effective tool for evaluating a firm’s ability to generate actual cash flow that can be used to service both interest and principal on debt. However, free cash flow measured to include growth-related increases in working capital and capital expenditures may be an overly-restrictive hurdle for a borrower to achieve. A useful fallback position is a free cash flow measure that excludes the cash requirements of growth. Borrowers that generate positive free cash flow calculated in this way are truly able to handle their debt service requirements.
Charles W. Mulford is Invesco Chair and Professor of Accounting at Georgia Tech’s Scheller College of Business.