Differences Between EBITDA and Operating Cashflow

Posted by John Nicklas

EBITDA is often used and confused as an approximation of operating cash flow. Many business professionals (CPAs, business owners, bankers, attorneys and others) struggle to understand the differences between EBITDA and cash flow from operations within a business. Below are some differences between these business metrics.

Definitions of each as provided by Investopedia.com:

1. “EBITDA” is essentially net income with interest, taxes, depreciation, and amortization added back to it, and can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions.
2. “Operating Cash Flow” or “OCF” is (in accounting) a measure of the amount of cash generated by a company's normal business operations. Operating cash flow is important because it indicates whether a company is able to generate sufficient positive cash flow to maintain and grow its operations, or whether it may require external financing. OCF is calculated by adjusting net income for items such as depreciation, changes to accounts receivable, changes in inventory and other working capital items. 

The table below compares EBITDA to OCF.  A 3rd column (“Example”) is presented for discussion purposes:

A few comments about EBITDA:

1. EBITDA is used widely and is easy to calculate by taking income from operations (reported on the income statement before interest and taxes) and adding back depreciation and amortization (reported as a line item or items in the cash flow statement).
2. EBITDA is used everywhere, from valuation multiples to the formulation of covenants in credit agreements. It is the “go to” or “de facto” metric in the business community.
3. EBITDA allows you to compare the profitability of different companies by cancelling the effects of a company’s capital, financing and tax entity structure.

Keep in mind the EBITDA does not equal cash flow. The most obvious shortfalls of the EBITDA calculation as a measure of cash flow are that the EBITDA calculation does not (1) consider the increase (or decreases) in working capital accounts that may fluctuate with a business as it grows and (2) it does not subtract capital expenditures that are needed to support production, especially in a manufacturing environment.

In the table above, Operating Cash Flow(“OCF”) does a better job of adjusting for the increasing working capital needs of a growing company, but fails to add back interest expense and income tax expense, items that make it easier to compare businesses with different capital and entity tax structures.

In addition to the fluctuation of working capital, we should include “normal” capital expenditures in our evaluation of the profitability of a company. Capital expenditures are necessary to support production and maintain a company’s asset base. As presented in the table above, capital expenditures may significantly impact cash flow if the business is capital intensive and/or has a need for expanded capacity or updated equipment.

EBITDA is, and will probably always be, the key business metric for evaluating the performance of a business to its peer group because it is widely used and easy to perform. However, keep in mind that EBITDA is not cash flow and that many other factors should be considered.

John Nicklas is a Vice President in our Assurance Service Group at Meaden & Moore. He has over 19 years of experience serving the accounting and business advisory needs of middle-market companies. He is born and raised in Northeast Ohio and works in our Cleveland office.

Managing cashflow: get more bang for your startup buck

A common error for fledgling businesses is to get bogged down by branding and marketing costs, says James Caan

 

It may be difficult to see where your money would be best placed at the startup phase. 

 

Getting the finance to start your business is often seen as the biggest obstacle to starting up. But what is even more significant than accessing those initial funds is how to make your money go a long way. Sometimes it is difficult to see where your money will be best utilised, particularly at the start-up phase of any business. This is all the more important when you are invariably bootstrapping, putting some of your personal savings towards your venture to keep your business developing. So how can you get your money to make you money?

In the first six months of 2013, the UK's startup activity was up by 3.4% on 2012, with more than 90,000 new ventures. With this rate of business creation in the UK, it is inevitable that many will fail. To avoid this, you need to steer clear of making big financial mistakes, because there is nothing worse than your business losing more money than is necessary. As I have always said, if you're going to fail, you should do it quickly. Failure can be a great lesson, but it should not destabilise any future ideas from coming into fruition because the financial cut is so deep.

Today 49% of small business owners say they started up with less than £2,000, a seemingly astonishing feat. But there are clear ways you can avoid extra costs. A big one is not hiring until you are ready, employees are one of the biggest costs in any new business. That being said, there is no doubt that they will be the ones who in the future can drive your business forward, but you must be able to justify new hires, especially at the early stages of a business. Bringing on board people you do not greatly require is an expensive problem, so you may want to consider hiring part-time support or sub-contractors, depending on the demands of your startup. And although admin work can be exhausting, juggling it along with other aspects of the business can help to make you a more dynamic entrepreneur and help round your skillset.

Do not underestimate the time it takes to set up. Starting a business will always take up more time than you will have imagined, and cost more than you would like it to. For these reasons you have to be flexible, and should not drain your resources too soon. With human error, slow vendors, changes to technology and extenuating circumstances – both personal and professional – not everything will go perfectly to plan. This is why you must be more tactful and cautious with spending, so that when you have to compromise on timing, you have a cushion of support.

A common error for startups is to get bogged down in branding and marketing costs. It is unbelievable just how much you can promote your business at little cost. Social media platforms such as Twitter, Instagram and Facebook are brilliant ways to engage potential customers, and SEO is a valuable and free content-based tool to get your business noticed. Of course, the cost of your time is valuable, but spending money on expensive branding companies can harm your resources, particularly as a new venture when your direction is evolving and most susceptible to change. Wait until you have been trading for at least six months before heavily investing in the branding side of your business. You will be in a much better position if you do.

Start-Up Loan recipient Karine Bono, a young fashion designer from London, understands the difficulty of starting up on a budget. With her £5,000 loan, Karine minimised expenses by producing all her garments and designs at her home studio in Hackney. By trading her clothes on Etsy, a popular clothing site, Karine is gaining exposure without breaking the bank, not spending too much on marketing but still benefitting from an online presence.

It is undeniable that new businesses have to find a way to manage their costs if they have any chance of survival. This is why the first sale is so important, and creating a profitable business is key. At the start be frugal and push yourself so you don't have to push others. After all, taking on challenges is what being an entrepreneur is all about.

James Caan is chairman of the Start-Up Loans Company. Each fortnight he tackles a different business issue for the Guardian Small Business Network. 

The Do's and Don'ts of Cash Management

By: Bronwen Roberts

Working capital is a highly effective barometer of a company's operational and financial efficiency and effectiveness. The better its condition, the better placed the company is to focus on developing its core business.

The early, primitive attempts at maximizing cash management can be traced back to the late 1970s. Unbelievably, there are still some companies who haven't yet understood that putting cash trapped in the balance sheet to better use can give them a competitive edge over their rivals.

A most recent report shows a further reduction of working capital in companies in the US and Europe compared with the previous year, of between 3 per cent and 5 per cent. This demonstrates the continuing increase in the importance of working capital management to help companies achieve their strategic objectives.


How to do It
There is more to working capital management than simply telling a company to collect its debtors as quickly as possible, to delay paying its suppliers as long as possible, and to keep stock levels as low as possible. A properly conceived and executed improvement program will certainly focus on optimizing each of these components, but will deliver additional benefits that extend far beyond the merely operational. It will demonstrate the need for ambitious corporates to integrate working capital management into their strategic and tactical thinking, rather than view it as an optional bolt-on extra.

There are a number of dos and don'ts to help guide corporate thinking. Firstly, do think of working capital management as a strategic objective that can enable your corporation's goals. We cannot over-emphasize this opening point. The same factors that drive a company's working capital also drive its operating costs and customer service performance. Therefore, by addressing the drivers of working capital a company will also experience significant improvement in operating costs and customer service.
 
For example, a company's working capital is deteriorating due to an increase in past due accounts receivable (AR). A review of the overdue AR illustrates a high level of customer disputes. The disputes are taking on average 30 days to resolve and consuming significant amounts of sales, order entry, and cash collectors' time. By tackling the root cause of the disputes, in this case poor adherence to pricing policies, the company can eliminate the disputes, thereby improving customer service.

This will free up the time of staff in sales, order entry and cash collections, enabling them to be more effective at their designated roles. This in turn increases productivity, reduces operating costs, and potentially increases sales. Working capital will improve, as customers will have fewer reasons to hold payment. This example illustrates how working capital is one of the best indicators of underlying inefficiency within an organization.

Consider Another Perspective
Don't think of things only from your own company's perspective. If you can help your own customers plan their inventory requirements more efficiently, for instance, you can match your production to their consumption, efficiently and cost-effectively, and do the same with your own suppliers. The potential implications for inventory levels are huge. By aligning ordering production and distribution processes, you increase inherent efficiency and achieve direct cost savings almost instantly, as a by-product. And then you discuss the best way to bill or to pay.

Do educate your organization to consider the trade-offs between different working capital assets when negotiating with customers and suppliers. Depending on the usage pattern of a raw material, there may be more to gain from negotiating consignment stock with a supplier versus pushing for extended terms. This could apply particularly in cases of long lead-time items, or those that require high minimum order quantities.

Agree Formal Terms
Do agree formal terms with suppliers and customers and document those terms carefully. Keep them up to date, and communicate those payment terms to employees throughout your business, particularly those involved in the customer to cash and purchase to pay processes, including your sales organization.

Don't allow prolific new product introduction without a clear product range management strategy. Poor product range management creates inefficiency in the supply chain, as companies are required to support old products with inventory and manufacturing capability. This increases operating costs and exposes the company to an obsolete inventory that may have to be disposed of.

Collect your Cash
Don't forget to collect your cash. Many businesses fail to implement effective ongoing collection procedures to prevent excess overdue funds or build-up of old debtors. Ask customers if invoices have been received and are clear to pay. If not, identify the problems that are preventing timely payment.

Confirm and reconfirm the credit terms agreed upon with the customer. Often, credit terms get lost in the translation of general payment terms and what's on the payables ledger in front of the payables clerk. Do devote the requisite amount of time and attention to the critical issue of dispute management.

Don't set top-down targets uniformly across the business. For instance, too many companies impose a 10 per cent reduction in working capital for each division. This fails to take into account the potential opportunity within a division and can result in setting an impossible target that acts to de-motivate. Instead, balance top-down with bottom-up intelligence when setting targets.

Targets Drive Behaviour
Do set targets that drive the desired behaviour. Many companies will incentivise collections staff to minimize the aged AR over 60 days. Does this mean that customers who pay one to 60 days late are good payers? No, aged AR over 60 days will result in increased costs and time it takes to collect the debt. By incentivising staff to lower the amount over 60 days, you keep your costs down. Do educate staff, customers and suppliers that cash and cash management are important, and are an integral part of a successful business relationship.

Look Within Yourself
Don't assume that all the answers are to be found externally. Before approaching existing customers and suppliers to discuss cash management goals, fully understand your own process gaps so you can credibly discuss poor payment processes.

Do treat suppliers as you would like your customers to treat you. Far greater cash flow benefits can be realized by strategically leveraging the relationship you have with suppliers and customers. In addition, a supplier is more likely to support you in an emergency if you have treated them fairly.

Don't however, treat everyone the same. Use segmentation tactics to split your customer supplier into similar groups. This may be based on a basket of criteria including profitability, sales, AR size, past due debt, average order size and frequency. Define strategies for each segment based around the criteria and your strategic goals.

Do celebrate success in hitting targets. Emphasise the actions that helped you get there.

Conclusion
To summarise briefly, following the dos and don'ts will enable you to optimize cash and to highlight inefficiencies in your processes that must be remedied to better serve customers. It will enable you to build stronger partnerships with your suppliers across the total working capital value chain. This translates ultimately into improvement in bottom-line results, often a good deal quicker than you might expect, and helps clarify the senior management focus on strategic imperatives. 

Author Bio
REL Consultancy Group www.relconsult.com are global specialists in generating cash improvements, cost reductions and service enhancements by optimizing working capital. They are the only international corporate financial consulting firm that focuses exclusively on increasing operational efficiency from working capital and operations. They work with people to transform your organization, your customer's and your suppliers in more than 60 countries around the world.