EBITDA overestimate CFO

Can someone please explain: “EBITDA overestimates cash flow from operations if working capital is growing”

CFO captures the changes in working capital accounts. If working capital is increasing (CA increase more than CL), then the firm is using cash to build up those CA’s. EBITDA does not capture the changes in working capital accounts, hence, it overstates CFO

May I know why EBITDA ignores the effects of differences in revenue recognition policies on cash flow? Thanks.

I believe it’s generally because you could manipulate receivables/payables to increase EBITDA while not collecting from your sales and/or overpaying your suppliers. I think an example would be how firms can use bill and hold sales to crank up EBITDA but never actually collect the cash.

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!


Are you implying US GAAP here because as far as I know IFRS, CFO indirect method is calculated from EBT.

Profit before tax + Non cash charges -Increase in WC, which is not exactly EBITDA (interest is left out).

Though I have spent a lot of time cracking the intuition here, I think the original statement is stating the obvious and is not worth much. It basically says that EBITDA can be high due to accrual accounting while high accruals do not affect cash flows. So you are bound to make a mistake only if you consider EBIDTA as a proxy for CFO.

yoiu are comparing ebitda and CFO(making ebitda ur cfo in essence)

and thereby ignoring changes in wc

if your wc is growing … ebitda overstates cfo

That’s what I’m saying. If you don’t assume EBITDA ≡ CFO you won’t have the problem in the first place.

That is correct, but thats not what the question asks. The whole point of the question is to determine if you know the differences basically.

Actually, you start with _ net income _, add non-cash charges, subtract non-cash revenues, add losses, subtract gains, then subtract the change in net working capital.

I said “essentially EBITDA” because I didn’t want to complicate the discussion with taxes and interest and gains and losses and lose the focus. The point was to focus on EBITDA vs. CFO.

OK, thanks. I got the main point.

understood well. you looked at account receivables increasing. can any other metric make this misleading?

Lower payables as a result of a narrowing commercial credit from suppliers would imply a higher Working Capital assuming bussiness volume is unchanged. Other example could be sudden changes in business model that requires a higher level of inventories or supply inneficiencies that requires pile stock inventories to prevent possible shortages.

At the end, any combination of monetary short term assets and liabilities that can increase investment in WC will derive a difference between CFO and EBITDA.
Note that Investment in WC = Δ(CA - CL)

thanks bro. makes sense.