Does EBITDA reflect cash flow?

Value in almost all deals is struck on a multiple of reported EBITDA. The basis is sound isn’t it?

The logic is that EBITDA does not include tax and interest or non-cash items such as depreciation and amortisation so therefore it should be a good proxy for pre-tax cash flows. It is a dangerous simplification. Buyers and investors should take particular care when assessing value and acquisition financing to ensure they adequately factor in (among other considerations) the following:

Maintenance capital expenditure in capital-intensive businesses

For example an equipment leasing business will need to renew its fleet every few years. Such replenishment or maintenance requires substantial funding but these amounts are capitalised and therefore not reflected in EBITDA

Research & Development costs

From our recent due diligence experience with several targets in the technology space, we have capitalised R&D claimed under tax legislation consequently inflating EBITDA. The issue is that the accounting treatment and commercial requirement for such expenditure is not as generous as the tax concessions. Even applying appropriate accounting treatment for capitalisation of development costs can still lead to a significant divergence between cash flow and EBITDA.

Increased working capital requirements due to growth or cyclical changes

Growth needs to be funded, new markets may be impacted by legislative changes and customer and supplier practices can have a material impact on a business’ working capital requirements.

Appropriate revenue recognition policies

There is a big move to “recurring revenue models” and we have seen significant changes in accounting policies of businesses in a variety of industries. If you are targeting a business that receives upfront, annual or multi-year payments from customers throughout any year, it is critically important to ensure the unearned revenue and associated costs of delivery are appropriately accrued over the contract term.

Multiples of EBITDA do provide a consistent basis to describe value, however, when making investment decisions be mindful that although theoretically EBITDA should reflect stable cash flows of a business, there are many things to consider. Remember, the value of an asset should only reflect the future benefits (future cash flows) you can obtain from it.