EBITDA and Working Capital

[thanhnguyen504]

Hi,

Can someone please explain to me why EBITDA will overestimate cash flow from operations if working capital is growing?

[cpk123]

In https://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/91333103

It’s not a matter of manipulating receivables and payables.

When you calculate CFO via the indirect method, you start, essentially, with EBITDA, then subtract the change in working capital. If working capital is growing, that change will be positive; by stopping at EBITDA, you don’t subtract that positive change.

Set a more clear example:

Working capital accounts are mainly receivables (CA), inventory (CA), payables (CL), short-term liabilities (CL). Note that short-term portion of long-term debt is not considered as a short-term liability in this case.

working capital = CA - CL, if WC is growing, then it is possitve, so CA is higher than CL.

Assume that CL has not changed and also inventories has not changed. The only account that has changed is receivables. When a company sales its goods or services, those sales can be exchanged for cash or credit. If the company sales on credit, receivables will increase. Because that sale was made that time, revenues account that sale despite it was made on credit. So here we have a first difference between revenues and cash flow.

Assume that receivables increased on $100, so revenues will increase on $100 and also EBITDA will increase on $100. Cash flow will increase $0 on that transaction.

If working capital increases systematically over time, EBITDA will be inflated in those working capital changes (assuming the other accounts don’t change). Thats why EBITDA can be used as a proxy of cash flows under certain assumptions or cases. Cash flow is always the best resource for valuation.

Hope this helped!

By comparing ebitda and CFO(making ebitda ur cfo in essence)

and thereby ignoring changes in wc

if your wc is growing …. ebitda overstates cfo

[self_employed]

A overestimates B => A > B

CFO = EBITDA(1-T) - WCInv

=> EBITDA > CFO when WCInv > -(EBITDA . T), which is likely true when WCInv is growing.