When it comes to valuing a business, there are several metrics that accounting and finance professionals use. Two of the most commonly used metrics are cash flow and earnings before interest, taxes, depreciation and amortization (EBITDA). The latter was designed to be a proxy for a company’s operating cash flow and is independent of how a company is capitalized, meaning it does not consider the company’s capital structure or financing decisions. While EBITDA can be useful for assessing a company's financial performance, it is important to understand its limitations and the critical role that cash flow plays in evaluating a business.

Cash flow (specifically free cash flow) refers to the actual cash that a business generates, and that flow is crucial for a company's survival and growth. Positive cash flows allow a company to invest in new equipment, pay off debts and fund research and development. Negative cash flows, on the other hand, can lead to business failure, especially if prolonged.

LIMITATIONS TO EBITDA

One of the biggest limitations of using EBITDA to value a business is that by itself it does not appropriately reflect the company's financial health or performance. EBITDA can be artificially inflated by non-cash items such as depreciation and amortization, which do not impact a company's cash flow (although they do represent a level of capital spending that may be required which is a cash outflow). This means that a company with a strong EBITDA might not necessarily have strong cash flows. This is often the case in certain industries that require a substantial amount of capital expenditure (e.g., manufacturing), resulting in higher depreciation expenses and driving EBITDA and cash flow further apart.

Another limitation of EBITDA is that it does not consider a company's debt levels. A company with high debt levels might have lower cash flows than a company with lower debt levels, even with the same EBITDA. This means that relying solely on EBITDA to value a business could lead to an inaccurate assessment of its financial health.

Therefore, while EBITDA can be a useful metric for evaluating a company's profitability, it is important to remember that it should be viewed alongside numerous other considerations to reflect a company's true financial picture.

FREE CASH FLOW

One often-utilized metric is free cash flow (FCF), which is the cash that a company generates after accounting for capital expenditures necessary to maintain or expand its operations and service the company’s current debt. Here are some factors to consider when evaluating a company's free cash flow:

1. Operating cash flow is the amount of cash that a company generates from its operations, including cash that is collected from customers and paid to employees and vendors. Accounting/finance professionals often look at trends in operating cash flow over time to see if a company is generating consistent cash flows from its core operations. It is worth noting that operating cash flow should be observed over multiple capital investment cycles to ensure that it is sufficient to meet reinvestment needs over the long term.
2. Capital expenditures (CapEx) are the funds that a company spends on property, plant and equipment (PP&E) and other long-term assets. Accounting professionals compare a company's CapEx to its operating cash flow to see if it is spending more than it generates in cash from operations. If a company's CapEx is consistently higher than its operating cash flow, it may be a sign that the company is investing too heavily in long-term assets or that performance is insufficient to maintain longer-term investment requirements.
3. Working capital is the difference between a company's current assets (e.g., cash, receivables and inventory) and its current liabilities (e.g., accounts payable and short-term debt). However, as a common practice, most M&A deals are negotiated and analyzed on a cash-free, debt-free basis (long-term debt), which means cash is always excluded from working capital. A company with positive working capital (excluding cash) may be indicative of the requirement for the company to keep cash invested or tied up in non-cash items such as inventory or receivables. Conversely, a company with negative working capital (excluding cash) may indicate that they are either able to convert collections to cash efficiently (which is good) or may struggle to meet its short-term financial obligations. Depending on the types of current liabilities driving the excess of current assets in evaluating a company, one should look at trends in its working capital over time to assess its ability to manage its short-term finances.
4. Cash balances observed over time can provide insight into the company’s overall financial health and its operating style. As it is commonly said, “Cash is king.” High levels of cash may be a preference due to a conscious decision made by the management team to keep cash on hand, or it could be reflective of the company’s lack of strategy and inability to deploy cash to generate returns or dividends to shareholders.
5. Debt can have a significant impact on a company's free cash flow. A company with high levels of debt may have to use a significant portion of its free cash flow to pay off the interest and principal payments, leaving less cash available for other uses, such as investing in new projects or returning value to shareholders.

HOW CASH FLOW ANALYSIS HELPS DECISIONMAKING

Keeping this in mind, all companies should implement a process to forecast cash flow (typically a 13-week forecast to ensure quarterly payments are captured) to use as an essential tool for managing and monitoring cash flows. A cash flow forecast offers a short-term outlook of expected cash inflows and outflows, allowing businesses to identify cash shortfalls and take proactive measures to manage their liquidity positions.

While EBITDA remains an important metric, cash flow analysis should be considered a critical component. Specifically, the company should evaluate its free cash flow, where one considers factors such as operating cash flow, capital expenditures, working capital and debt. By taking a comprehensive view of a company's financial health, one can better understand the company’s ability to generate cash flows and invest in future growth. With that in mind, a discounted cash flow (DCF) model is often considered the black belt of analytical valuation tools used by finance professionals.

To learn more about this topic, please reach out to GHJ’s Transaction Advisory Services Team.