How CFOs view EBITDA vs. OCF (Operating Cash Flow)

In this video, we'll discuss how a CFO views EBITDA versus operating cash flow. And as we'll see in the video, one focuses on profitability and the other on liquidity. One focuses on multiples and valuation and the other on the sustainability of the business. So if this sounds good to you, find yourself a cozy spot and let's dive right in. Hey guys, this is Bill Hanna, your favorite financial controller. I bring about 20 years of experience in corporate accounting and finance. And I teach here free lectures on YouTube as well as on my website, The Controller Academy, with the goal of developing the next generation of finance professionals. So jumping right into today's video, we are discussing EBITDA versus operating cash flow. EBITDA stands for earnings before interest, tax, depreciation, and amortization. And as you'll see in today's video, a successful CFO needs to consider both of these metrics. They need to focus on EBITDA and they also need to focus on operating Cash flow. So let's talk about EBITDA here for a minute. So EBITDA, as we said, is earnings before interest, taxes, depreciation, and amortization. And what it tries to do, it tries to look at a business and tries to answer the question whether the business is profitable on paper before considering some of the financing decisions like interest and some of the accounting noise like depreciation and amortization. So the formula for EBITDA takes net income and and it adds back interest, taxes, depreciation, and amortization. Interest because that removes any of the financing decisions for the business if you decide to take a loan to finance the business operation. Taxes because it's a non-operating item. Depreciation and amortization because that relies heavily on accounting rules. So by removing these things, you remove the financing decisions for the business and the accounting noise. But if you zoom out a bit to look at EBITDA, you'll see the income statement begins with revenue. You subtract COGS to get to gross profit. You subtract operating expenses after that to get to EBITDA. Beyond EBITDA, you subtract depreciation, amortization, interest, taxes to get to net income. So in this case, what we do with EBITDA is to answer questions like how strong the business looks. Does it look at least profitable on paper? It looks at the core operating profitability of the business. So core is because we added back interest and taxes. This is a non-core item for the business. Comparability across companies. So we can compare the profitability of companies by using EBITDA, especially when we take EBITDA and we divide it by revenue to get to EBITDA margin. That ratio can be used across companies to compare the profitability of different companies to each other. EBITDA is used in valuation and debt metrics. So in valuation, an example of that is a private equity firm is looking at a business for acquisition, they would look at EBITDA and then arrive at the valuation using a multiple of that EBITDA. Usually you want to get in at a low multiple and exit at a high multiple of that EBITDA. Therefore, EBITDA tells us whether the business model works on paper. Okay, now let's talk about operating cash flow, or OCF, which will tell us a very different story. Okay, as we said, OCF focuses on liquidity while EBITDA focuses on profitability. Let's look at the formula for OCF. The formula will begin with net income, which is very similar to how we did the calculation for EBITDA. Net income, and then we'll add back non-cash expenses. Example is depreciation and amortization, which is again very similar to EBITDA. Remember, EBITDA added back depreciation and amortization. We'll do the same here, but we'll also add back any non-cash expenses. So that could be SBC, stock-based comp, or any other non-cash items that you have on your income statement. Okay, so we'll begin with net income, we'll add back non-cash expenses, and then we'll add or subtract the working, working capital changes. Well, what are examples of that? So working capital changes, working capital, remember, AR, AP, inventory, things like that. So with AR, accounts receivable, Let's say AR went up. That means your cash went down because you're building up your AR balance. Building up your accounts receivable balance signifies that your cash balance went down. So that would be a reduction or a subtraction, right? Inventory, inventory going up. It means if the balance of inventory is going up, it means that you're buying more inventory. Your cash will go down. Makes sense, right? Accounts payable, accounts payable going up. What does that mean? If you're building up your accounts payable balance, it means that you're preserving your cash, which means that your cash will be going up. Okay, so we said the formula takes net income, adds non-cash expenses, adds or subtracts working capital changes as we've seen here. And by the way, if you like this video, go ahead and hit that like button because that is the only way for me to know that you like this content and share it with someone who will benefit from learning about EBITDA versus OCF. Now, what does this tell us? Well, it tells us the real cash the business is actually able to produce, right? So it's all good on paper to have all this profitability, but it's no good unless we're able to collect it fast enough to use it in the business. It tells us our ability to pay payroll, vendors, and rent, and all the recurring obligations that the business has overall. It It tells us about the sustainability of this business. So it's profitable on paper, but are we able to manage our working capital efficiently to be able to sustain and grow the business? If you're enjoying my style of teaching and ready to invest in a comprehensive financial analyst course, be sure to check my FP&A Academy where I teach you the entire function of the financial analyst over the course of 8 hours. If you're interested, Check out the link in the description below. We begin by establishing a 5-year financial plan for the company. Then we draft together the budget for the upcoming year. We then learn about the financial statement analysis using real-life data. We finally discuss the best practices in creating management presentations. If you're interested in joining me in the course, find the link in the description below, head over to the website, and check out the detailed curriculum. Therefore, OCF, or operating cash flow, tells us whether the business is able to actually generate cash to sustain the business. Okay, let's look at some of the CFO insights that we get from looking at EBITDA and OCF. So the focus with EBITDA is profitability, like we said. With OCF, it's liquidity and sustainability of the business. Are we able to have enough cash to survive as a business? With depreciation and amortization, that is added back both in EBITDA. We're going to add that back. Remember here, we added back depreciation, amortization. We'll also add it back as a non-cash expense in OCF. Working capital changes. So we've seen working capital changes here affecting our operating cash flow, but here EBITDA actually ignores working capital changes. It doesn't look at that. So ignores working capital changes, focuses and exposes any inefficiencies in working capital. That's why successful CFOs looks at OCF because that's what's going to expose any problems or inefficiencies in working capital. So cash reality obviously not reflected in EBITDA, but it is reflected here in OCF. Uh, the use— EBITDA is used heavily in valuation and multiples. OCF is the survivability and the planning of the business because you may have all of these dreams to make your business profitable, but if you don't have the cash to see it through you're obviously not going to succeed. Also very important, why do we care about this in real life as a CFO? So in many cases, you find companies have high EBITDA and low operating cash flow. So a high EBITDA means that the business is profitable, but the low operating cash flow in many cases just signifies the inefficiency of working capital. So it means that maybe you're not collecting fast enough from your customers, uh, you're not managing your inventory well, you're buying it too fast. And unable to turn it around. So it's not a profitability problem. It's more of a cash conversion problem. So that's one of the cases that I see. The other case that I see is a business with a low EBITDA and a strong operating cash flow. So this is more of a modest business. It may not excite investors fast enough because it has a low EBITDA, but it's a resilient business because it's managing its cash effectively, getting its cash from customers fast, maybe charging upfront, and it's able to manage its working capital effectively, and therefore it can weather any disruption that it may have. So overall, with EBITDA and OCF, one focuses on profitability and the other on liquidity. One is used in valuation and multiples, and the other is used to assess the sustainability of the business. Uh, with EBITDA, we ignore working capital changes. OCF exposes working capital inefficiencies And a strong CFO will consider both EBITDA and OCF because EBITDA tells us about the core operating profitability of the business, while OCF helps us with cash planning and forecast, which is used in hiring, inventory planning, and the overall management of the business. 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